Plenty of investors are familiar with the term "value investing," but many may not how to properly apply value investing techniques. The primary tenet of value investing is discovering companies that trade at prices below what a combination of fundamental indicators show the company may be worth. While not all investors focus on value, learning some common value investing indicators can help improve your portfolio.
One of the most often-used value investing indicators is the price-to-earnings, or P/E, ratio. To determine a stock’s P/E ratio, take the share price and divide it by the company’s earnings per share. Companies with high P/E ratios relative to competitors are considered overvalued, while the opposite can be said of low P/E companies. While the concept behind the P/E ratio is easy to understand and apply, it is not 100 percent accurate on its own because companies with a lower P/E ratio can be bad values while a high P/E company can prove to be a bargain.
A company’s book value is its total net assets after liabilities are subtracted. Investors can calculate the price-to-book ratio by dividing the stock price by the book value per share. A low a price-to-book ratio can imply a company’s current book value is not being accurately reflected in the share price or that the stock is undervalued. However, as is the case with the P/E ratio, price-to-book should not be used alone because it is possible that some low price-to-book ratio stocks are not good value propositions.
Return On Equity
Return on equity (ROE) measures the return on shareholder equity and is calculated by dividing net income by average stockholder equity. Effective use of ROE is pivotal for value investors because a "company can only create shareholder value, economic profits, if the ROE is greater than its cost of equity capital," according to the Financial Times. Bottom line: ROE tells investors how well management uses shareholder capital to generate profits.
Free Cash Flow
Free cash flow is the cash a company has left over after making general business investments. It is calculated by subtracting capital expenditures from operating cash flow. In application to value investing, investors want to identify cash-rich companies because that means those firms have war chests with which to commit to vital corporate actions such as acquisitions, research and development and dividend payments. When free cash flow greatly exceeds earnings, that could be a bullish sign, according to Barron’s.
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