Updated: Mar 1, 2021
Do you want to invest in profitable and growing companies, and do you want to buy them for less than they might be worth? If so, you want to be a value investor. Value investors have been wildly successful over the years. They use publicly available information to find high performing companies at a discount, and so can you, if you follow this guide. As always, reach out to firstname.lastname@example.org with any questions, go check out our Forum, and talk to your Certified Financial Advisor before making any moves with your money.
The Price-to-Earnings (P/E) Ratio is one of the most common and easy to understand financial ratios. It takes the price for one share/stock of a company and divides it by their Earnings Per Share (EPS). Investors use the P/E to measure the market value of a company versus their earnings. Another way to use a company’s P/E is as a measure for how much you will pay for a piece of their profits. Know this: if a company does not have a P/E it simply means they have zero earnings, or they are losing money. Value investors like to pick companies with low P/E and hold onto them for long periods of time. Let’s take a peek at the P/E for a famous electric car manufacturer, Tesla (TSLA).
So, that means investors will pay $1,244.09 for every $1 TSLA generates. Seems expensive, right? Well, it is, but there’s a couple different things that a high P/E might mean. Either the company is indeed overvalued and hyped up by its own popularity, or investors are expecting much higher earnings in the future and are willing to pay more now for a piece of a company they believe will do well long-term. Now, notice we used the acronym (TTM) that stands for Trailing Twelve Months. Conversely, you may find Forward Looking P/E Ratios which use the projected EPS, or analyst predictions of what EPS will be in the future. Both types of P/E Ratios have their shortcomings. TTM uses historical data, which we know does not guarantee future results. A Forward P/E uses analyst estimates, which may not always be accurate. A smart investor will use both forms of a P/E Ratio (and other ratios) and come to their own conclusions on whether a company is a good value.
PEG stands for Price/Earnings-to-Growth. This is simply a modified version of the standard P/E Ratio we just learned about, but PEG actually enhances the P/E and gives investors a little more information by taking into account estimated future earnings growth. The calculation is simply P/E divided by earnings growth. Stocks with a PEG less than 1 are often considered undervalued. Keep in mind the P/E we calculated for TSLA while we take a look at the PEG Ratio for one of the biggest companies in the world, Amazon (AMZN).
Wait, hold up, why is TSLA P/E ratio over 15x that of AMZN? One share of Amazon is over $3,000 what gives!? Remember, the P/E Ratio takes into account earnings per share, and AMZN is an absolute earnings juggernaut. Even so, AMZN PEG is over 1, so does that mean it’s overvalued? Maybe. There’s plenty of other things to consider when trying to value a stock, and we’ll look at some of those next.
Free Cash Flow
Okay, this isn’t a ratio by definition, but it is a good measure of how well a company is performing financially. Free Cash Flow is just that: how much cash the company is producing freely through it’s operations after paying off any expenses. Investors like to look at FCF for many reasons, but the best is perhaps this: FCF is a leading indicator. In other words, a rising FCF will typically be seen before a rise in earnings per share. Here’s a look at the cash flow trend for a stock that was making headlines just a few weeks ago, GameStop (GME).
Negative $493 million…ouch! If a rising Free Cash Flow means a company is making more money than previous years and may perform even better in the future, what does a declining FCF mean? You be the judge.
The Price-to-Book Ratio (P/B) shows value investors the difference between market value and book value. In other words, P/B compares how much the market currently thinks a company is worth versus how much it is truly worth. It’s a more conservative way to measure a company’s worth. P/B Ratios near 1 indicate the company is trading at or close to its book value. You can find a company’s Book Value Per Share on their Balance Sheet; it’s public information available online. We can easily calculate the P/B for tech giant Microsoft (MSFT).
So, what does this tell us? Well, 14.12 is a lot higher than 1, so we know MSFT is trading well above it’s book value. Before making any conclusions, it is important to research the company and determine why the market may be willing to pay more than a company is worth on its balance sheet.
A.K.A. the acid test, the Quick Ratio gives investors an idea of how quickly a company’s outstanding Liabilities (debts) can be paid off by Liquid Assets (cash). Here’s what you do to perform the acid test: take (Total Cash + Receivables) and divide it by Liabilities. You can find this data for any publicly traded company easily online. This is a real example using data as of 9/26/2020 from a company you may have heard of, Apple (AAPL).
Usually, a Quick Ratio greater than 1 indicates a healthy amount of Liabilities compared to Cash balances. However, if the ratio is too high it could mean that the company doesn’t have a great use for the cash it has, or the company is not reinvesting its profits. Investors expect a return on their investment, and a large cash balance does not necessarily guarantee the company will be doing well in the future.
P/E Ratios help determine the value of a company’s stock relative to its earnings.
PEG Ratio modifies the P/E Ratio to factor in future earnings growth.
Free Cash Flow lets investors see if the company is profiting from operations.
P/B Ratio compares the market value of a company versus its book value.
The Quick Ratio gives investors an idea what companies are doing with their cash.
Now show us what you can do! Try using these ratios to compare two similar companies and determine which is a better value for you. Look at big names like Ford vs General Motors, or Wal-Mart vs Target.
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This article is for educational purposes only and is not intended to be taken as investment advice. Coast to Coast Finance does not own a position in any of the stocks mentioned in this article. All investments involve risk and the past performance of a security or financial product does not guarantee future results or returns. Keep in mind that while diversification may help spread risk, it does not assure a profit or protect against loss. There is always the potential of losing money when you invest in securities or other financial products. Investors should consider their investment objectives and risks carefully before investing.