An Analytical Approach to Identifying Value Stocks Through Key Metrics

Good Morning Ladies and Gentlemen

”Most investors steer their portfolios with only the benefit of the rear view mirror.”

Jesse Felder

In last week’s edition of Stefan’s Weekly, “Embrace the Power of Value Investing,” we explored various facets of value investing. Today, I want to share some key metrics you can utilise when adopting this investment approach.

How Should We Define Value Stocks?

To begin with, let’s clarify the definition. In simple terms, value stocks trade on the stock exchange at prices lower than their intrinsic worth. These stocks typically exhibit strong financial fundamentals, such as low debt levels, stable profits, a reliable business model, and a lengthy company history. Investors who follow a value investing approach seek out and purchase undervalued shares that presently underperform in the market and do not show immediate growth potential. The hope is that growth will eventually return, the market will recognise the “true” value, and the stock price will rise to align with its fair value.

How Can We Identify Value Stocks?

Having established a definition of value stocks, the next important question is identifying these potentially undervalued investments. The process of pinpointing value stocks necessitates a thorough fundamental analysis of companies, with time being a crucial factor. To assist in this identification process, analysts typically utilise several key metrics to uncover stocks that may be undervalued. While no single metric is deemed the ultimate indicator, their combined use strengthens the analysis and supports a more accurate company evaluation. These metrics‘ preference for and weighting often come down to personal judgment. It can lead to slightly differing company assessments, varying from sector to sector or company to another. While this subjectivity can complicate the task for asset managers, it also reflects the nuanced nature of investment analysis. Now, let us explore some of these key metrics.

The Classic: Price/Earnings Ratio (P/E Ratio)

The P/E ratio is one of the most recognised indicators of stock valuation. It is calculated by dividing the share price by the earnings per share. Generally, a lower P/E ratio may indicate that a stock is undervalued. However, it is crucial to consider these ratios in the context of different sectors, as various industries tend to have distinct P/E ratios. The classic P/E ratio is the first metric I examine when evaluating a potential investment. Additionally, I assess the company’s P/E ratio trend over the past few years, determining whether it has risen, fallen, or remained stable, and I compare it to its peers within the sector.

For Deep Value Seekers: Price-to-Book Ratio (P/B Ratio)

The price-to-book (P/B) ratio compares a company’s share price to its book value per share, which is calculated by dividing the company’s equity by the total number of shares outstanding. A P/B ratio of less than 1.0 may indicate that the stock is undervalued, suggesting that the market price is below the estimated net asset value. However, the challenge with this metric lies in the reliability of the equity valuation. It raises questions about how and by whom this calculation is performed. Analysts often lack direct access to a company’s assets and base their assessments on annual reports and their assumptions. Additionally, a company might trade below its book value if it consistently incurs losses from its operations. While the P/B ratio can be a factor to consider, it should not be the sole determinant of an investment decision.

Price/Earnings Growth Ratio (PEG) 

My partner, Dr. Christian Schärer, advocates for the PEG, which relates the P/E ratio to anticipated earnings growth. This metric is calculated by dividing the P/E ratio by the earnings growth rate. A PEG value under 1.0 is typically viewed as favourable, indicating a potential undervaluation of the shares.

Liquidity Ratio (Current Ratio)

During my early career, I worked in the staff unit supporting the CEO of UBS. My superior, who served as chief of staff to the CEO, frequently emphasised the importance of liquidity and the Current Ratio. A company’s liquidity ratio evaluates its capacity to fulfil its debt obligations, calculated by dividing fixed assets by liabilities. A liquidity ratio below 100% suggests that available fixed assets are inadequate to cover the liabilities. The lower the liquidity ratio, the higher the risk that the share price will continue to decline, potentially leading to the stock being undervalued.

Debt-Equity Ratio

Another essential ratio for deep value seekers is the debt-equity ratio, which assesses the proportion of total debt relative to equity. Generally, a low gearing ratio (below 1.0) is seen positively, as it suggests that the company relies less on debt financing and can adapt more readily during times of crisis. However, this ratio’s importance is diminished in a zero-interest-rate environment like Switzerland.

Return on Equity (ROE)

Return on equity (ROE) is another key financial metric that assesses the efficiency with which a company employs its shareholders‘ equity to generate profits. It is computed by dividing the annual net profit by the total equity possessed by shareholders. A high ROE indicates a robust and profitable business model, reflecting the ability of the management to maximise returns on equity investments. This measure is essential for investors and analysts in evaluating financial performance and determining the potential for capital growth within an organisation.

Earnings Yield or Inverse P/E Ratio

The earnings yield represents the inverse relationship of the P/E ratio and is computed by dividing earnings per share by the prevailing share price. A share is deemed attractive when its earnings yield exceeds the yield offered by risk-free government bonds, indicating a potentially higher return on investment than a virtually riskless asset.

Dividend Yield

Lastly, dividend yield serves as a crucial financial metric that quantifies the proportion of a company’s share price that is allocated to annual dividend distributions. A robust and sustainable dividend yield possesses the capacity to significantly augment total returns, particularly in contexts where the underlying asset is perceived to be undervalued. This correlation emphasises the critical role of dividend yield within the framework of investment strategy and valuation assessment in equity markets. Personal investment analysis often prioritises the long-term trajectory of the dividend itself, as this metric can provide deeper insights compared to dividend yield, which is inherently influenced by fluctuations in share price.

Conclusion

In a 2016 OECD survey, it was revealed that many individuals struggle to grasp even basic financial concepts, such as compound interest. Given its slightly more complex nature, value investing is likely understood by even fewer. Through “Stefan’s Weekly,” my aim is to assist readers in making informed investment choices. However, I urge you not to underestimate the intricate dynamics of financial markets, where capital intersects with risk and opportunity. As asset managers, we delve into the captivating ideologies that shape our aspirations and decisions. Each investment presents an enticing yet unpredictable encounter. Beneath the surface, misunderstandings linger like echoes in a dimly lit room, prompting us to reevaluate our perceptions. An approach like value investing provides a clearer perspective on our investments, even if we ultimately gravitate towards a different investment style or a hybrid variation of it.

Next Week

Next week’s edition of “Stefan’s Weekly” will explore “A Deeper Look at Wealth / Part II.” Just as with the first part, Anton will provide the text while I handle the editing. Hopefully, some of your questions from part one will be addressed, and perhaps new inquiries will emerge.

Ladies and Gentlemen

Feel free to send your messages to smk@incrementum.li. Many thanks, indeed!

I wish you an excellent start to the day and weekend!

Yours truly,

Stefan M. Kremeth
CEO & Head of Wealth Management
Incrementum AG – we love managing assets

Tel.: +423 237 26 60
Cell: +41 79 303 48 39
Im alten Riet 153
9494 Schaan/Liechtenstein
Mail: smk@incrementum.li