One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway from $12 a share in 1967 to an astonishing $70,900 in 2002. Although Mr. Buffett does not hold himself only to value investing, most of his investments were made on the basis of value investing principles.
A value investor looks for stocks with strong fundamentals or strong earnings, dividends, growth, and cash flow. The basic principal of value investors is that you should first find out what the true price of a share of stock is and then determine if it is undervalued. After you have determined its stock price is below what it should be you would then buy and hold it until it gets back in equilibrium. There are several ways to find out exactly how much a certain stock is worth. The most basic way to do this is determining the company's book value. Book value is calculated by subtracting total liabilities from total assets. If a company has a history that you can go back and check to see what it's average market value to book value ratio this method would prove to be a key factor in your valuation. We can't stop with just book value though we must dive deeper.
The next major indicator I would look at is price to earnings ratio. The P/E ratio determines how the market feels relative to the earnings that the company is making. You would want to look at the stocks historical P/E ratio and determine where their current P/E ratio relative to historical. If it is below the historical average, we could say that the stock is undervalued.
A lot of the time when I'm picking a stock with this method I will also look at the major stock holders and try to determine if any hedge funds or other big institutions have picked up this stock recently. If they have then I will just move on to another stock because it has already been discovered.
Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:
• Share price should be no more than two-thirds of intrinsic worth.
• Look at companies with P/E ratios at the lowest 10% of all equity securities.
• PEG should be less than one.
• Stock price should be no more than tangible book value.
• There should be no more debt than equity (i.e. D/E ratio < 1).
• Current assets should be two times current liabilities.
• Earnings growth should be at least 7% per year compounded over the last 10 years.
Remember these are rough guides. You can always try out some new stuff and see how it works for you. Value investing may not seem as sexy as some other styles of trading or investing but it relies on a strict screening process that helps you get to know the company you are buying in order to make the best decision.
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