How to Find Value Stocks
Okay, with the situation in Ukraine and the remnants of the epidemic still with us, what are you doing with the markets? Yes, the markets are volatile right now, and in many instances, the values of stocks are high, if not outright overvalued. But there is hope if you are willing to put in the effort and look for hidden gems. Even in today's market! So how do you go about finding these hidden gems? By looking into what you know and using some of the valuation techniques, we will look at in this post.
Seek Out Companies
The first step is to look at companies you know and understand. In this part, try to come up with 25 or more companies that you are familiar with and understand what they do to make profits. You do not need to know all of the ways a company works or profits, but you do need to have an opinion on if the company is well run, has a strong reputation, is stable, has the potential to grow, and has a track record of producing results. Yes, two years ago, the pandemic hit us, and the markets went south for a brief time. That is when we should have bought, but that does not mean there are no undervalued stocks in today's market.
Okay, so now you have your list of 25 companies that you will look at to see if you can find any undervalued ones. Here we will use stock screeners to sort out what looks good and not. To find a screener, you can use Yahoo, Google, or FinViz.
Now, depending on your preference, you can screen with most of the sites I mentioned for any number of criteria. But here are some that I use and find useful when I am screening a company to see if it is valued correctly or not. A good measure is a return on equity or ROE greater than 15, a second is debt-to-equity less than .5, and finally, a current ratio greater than 2. By using these three metrics, you are now looking for a highly profitable company that possibly has a competitive advantage. A company with a competitive advantage may have what Warren Buffett refers to as a MOAT, meaning it is insulated from its market due to its strength and product/service. For more information on what the meaning of MOAT is, visit MOAT. The final two metrics will tell us that the company does not rely on debt to finance its equity and maintains a position that will allow it to pay for its current liabilities with ease.
In many instances, I will also look for a company that pays a dividend. If you can find an undervalued company that meets the above criteria and pays a dividend, that is one to consider definitely. In this instance, you may say you found a value-income company, and if it does not pay a dividend, it may be a value-growth opportunity.
After the Screener
Hopefully, you will have some companies on your list that passed the three tests mentioned above. Now, you want to see a highly profitable company with healthy and steady profit margins, and this should lead the company to have the ability to increase its book value as well. At this stage, you will also want to ensure that the company is generating a healthy level of free cash flow (FCF). Be leary of any company that shows a net profit but does not indicate FCF, which could be a sign of earnings manipulation.
If the company passes the second and third criteria, that should indicate low debt levels, which is always good when investing in a value-based company. Debt is not necessarily bad for any company to have on its books, but too much debt may indicate issues with its ability to be a long-term investment.
The next two things to examine are more subjective to you, your knowledge, and your company impression. The company may have a competitive advantage or even MOAT from the ROE criteria, and here you will need to decide if that is indeed the case or not. If you think the company enjoys an advantage, you need to examine if management is shareholder-friendly. Look at how management approaches different issues that the company may face, such as relationships with employees or consumers. Is management a good steward of the company regarding how it utilizes the profits derived from operations and deployed to advance the company or reward shareholders further? This analysis will also aid you in deciding if the company is an income or growth-type investment.
Now, determine if the companies you are looking at are overvalued or undervalued. There are several ways this can be done, with some being complex requiring tools such as a spreadsheet, or they can use simple arithmetic. This post will examine the methods that use simple math and avoid complex methods such as discounted cash flow (DCF).
One easy method is the price to earnings or PE method. Here you will take the five-year forward PE and multiply it by the earnings per share (EPS). As an example is a company I invest in, I am not endorsing this company for you as you need to do your research to determine if it is right for your portfolio, Ollie's Bargain Outlet (OLLI). For this example, the forward PE is 18.9, and the price per share is $2.70 and, when multiplied, gives an estimate of $51.03. The second method is the price-to-sales (PS) method. For OLLI, the three-year average for PS is $3.366, and the sales per share are $26.95 and, when multiplied, gives an estimate of $90.72. Finally, there is the value from historic multiples where we add the two estimates we have calculated and divide by two. So, for OLLI, that would be $51.03 plus $90.72 for a sum of $141.76 divided by two resulting in a historic estimate of $70.88.
So is OLLI valued fairly in the markets based on these three estimates? As of February 25, 2022, the answer is no; it is not. We estimated three values of $51.03, $90.72, and $70.88, with OLLI closing at $43.46 on the 25th. To me, this means I would investigate OLLI more and see if it is a desirable investment or not.
Soon we will examine some of the more complex methods best done with the help of spreadsheets. But for now, this is a good start. Suppose you want more information or have any questions feel free to contact me directly or seek another fee-only Registered Financial Consultant near you. Though located in Metro Nashville, I can remotely help you no matter where you are.