Value investors search stocks that they believe is undervalued in the market. For value investors, the market overreacts to good and bad news.
What happens is that stock price movements do not correspond with a company’s long-term fundamentals.
As a result, value investors get the chance to invest when the price is deflated.
Even though there is no rock-solid metric or formula to follow when analyzing a stock, value investors use financial ratios to help them analyze a company’s fundamentals.
Here are the most common metrics that these investors use:
Price-to-Earnings Ratio
The price-to-earning ratio lets you find the market value of a stock in comparison to the company’s earnings. In other words, this ratio shows what the market is willing to pay today for a stock as they keep in mind the company’s past or future earnings.
A high price-to-earnings ratio could indicate that the stock’s price is high in comparison with the company’s earnings. That may also suggest that the stock is overvalued.
On the flipside, a low price-to-earnings ratio may indicate that the current stock price is low in comparison to earnings. In other words, a low figure for this ratio may indicate the company is undervalued.
There are some limitations, however. The company’s earnings are based on either historical earnings or forward earnings. These are based on the perception of analysts.
That means earnings can be difficult to predict because past earnings do not guarantee future results. Expectations can be proven to be wrong.
Price-to-Book Ratio
The price-to-book ratio gauges whether a stock is over or undervalued by comparing the net assets of a business to the price of all of the stock’s outstanding shares.
This ratio is a great indication of what investors are willing to pay for each dollar of a company’s assets. The ratio also divides a stock’s share price by its net assets. That is, total assets minus liabilities.
The price-to-book ratio is important to value investor is that it represents the difference between the market value of a company’s stock and the book value.
The market value represents the price that investors are willing to pay for the stock depending on the expected futures earnings. Meanwhile, the book value comes from the company’s assets. It is also a more conservative measure of a company’s worth.
Debt-to-Equity
The debt-to-equity ratio helps investors find how a company finances its assets. This ratio represents the proportion of equity to debt the business is using to fund its assets.
A low reading of the debt-to-equity ratio indicates that the company uses a lower amount of debt for funding against equity via shareholders.
A high reading of the debt-to-equity ratio indicates that the business is getting more of its finances through debt in comparison equity.
Free Cash Flow
The free cash flow refers to the cash produced by a business through its operations less the cost expenditures.
Put another way, the free cash flow refers to the cash left over after a company paid its operating expenses and capital expenditures.
The free cash flow shows the efficiency of a company when it comes to generating cash. It is also an important metric in finding whether a company has enough cash after financing operations and capital expenditures, to pay shareholders their dividends and share buybacks.
