John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
'Price is what you pay, value is what you get." Warren Buffett has said that's what he learned about value from his mentor Benjamin Graham, the man known as the "father of value investing." It's a great line and it's right on the money in broad terms. But when you think more specifically, the question becomes: How do you measure "what you get?"
There's no right answer to that question. When it comes to stock investing, you can measure value in numerous ways. Each method has its merits, and its flaws. And in a market like this one – where we're past the fire-sale, across-the-board low prices we saw early in the bull market – it's critical to understand how to find good values. So let's do some Investing 101, and look at some of the most common valuation metrics:
Price-to-earnings ratio
The P/E ratio is the most commonly used valuation metric. It divides a stock's price by its per-share earnings.
Pros: Earnings are the bottom line, giving you the final assessment of how much money a company has made during a certain period. What could be better if you are trying to gauge the value of the company's stock?
Cons: Earnings can be manipulated through accounting gimmicks, and they can fluctuate greatly depending on when a company decides to replace equipment, upgrade facilities or make acquisitions. In addition, the standard P/E doesn't take into account how much debt a firm is carrying on its balance sheet, which may obscure its real value.
Price-to-sales ratio
Kenneth Fisher, one of the investors upon whom I base my Guru Strategy models, pioneered the use of this metric back in the mid-1980s. The PSR divides a company's market capitalization by its trailing 12-month sales.
Pros: Sales are subject to far less accounting gimmickry and short-term volatility than earnings, often giving a better idea of just how strong a business's long-term prospects are.
Cons: Since it focuses on the "top line," the PSR doesn't account for things such as profit margins. In some industries, such factors make a huge difference in a company's prospects. And, like the P/E, it doesn't take debt into account.
Price-to-book ratio
The P/B ratio divides a stock's price by its book value, which is equal to its total assets minus intangible assets and liabilities.
Pros: Book value gives you an idea of what the company would be worth if you liquidated its assets and paid off its debts. It's thus a very good metric to gauge what a company has right now, including its debt.
Cons: While it gives you an idea of what the firm has now, the P/B doesn't tell you about its earnings power.
Free cash flow yield
FCF yield divides free cash flow (operating cash flow minus capital expenditures) by the stock's price. It shows how much money a company generates after it pays the costs of running and keeping up its business.
Pros: Accounting gimmickry can't mess with FCF the same way it can with earnings. FCF gives you a great idea of just how much cash a firm is generating to facilitate growth.
Cons: Large amounts of debt can make a high FCF misleading, as that free cash will be needed to pay off debt rather than facilitate growth. Plus, when a company actually is making big capital expenditures, its FCF can look very low even though the improvements it is making are key to future growth.
While these four are among the most popular, there are other metrics to gauge value. Hedge fund guru Joel Greenblatt divides a firm's earnings before interest and taxes by its enterprise value, a figure that does take debt into account.
So, which is best? That's a trick question. Over more than a decade of using my Guru Strategies, I've found that it's best to use multiple metrics when analyzing a stock. That's what three of my top performing strategies do. My best individual guru based model, the Graham-inspired approach, uses both the P/E and P/B ratios. And my Top 5 Gurus and Hot List approaches both use multiple strategies to pick stocks, meaning that they are employing a number of different valuation metrics.
The work of quantitative investing guru James O'Shaughnessy supports this idea. In the latest edition of his book What Works On Wall Street, Mr. O'Shaughnessy found that a composite value metric, which takes into account several different valuation ratios, produced returns better than any individual metric from 1964 through 2009.
Here are three North American stocks that currently look cheap on a few different levels, helping them get interest from my guru inspired strategies.
Nissan Motor Co. Ltd. (NSANY):
Nissan ($40-billion U.S. market cap) gets strong interest from my O'Shaughnessy-based value model. The approach likes that Nissan's cash flow per share ($4.63) is greater than the market mean ($1.73). It also likes the stock's big 4.8-per-cent dividend.
Power Corp. of Canada (POW):
This holding company has interests in the financial services and communications sectors. It gets approval from my O'Shaughnessy-, Greenblatt- and David Dreman-based models, thanks in part to its 13.8 P/E, 0.4 PSR, and 23.4-per-cent EBIT/enterprise value ratios. It also has a stellar 12-per-cent FCF yield.
Valero Energy Corp. (VLO):
This oil refiner gets strong interest from my Peter Lynch- and O'Shaughnessy-based models. Mr. Lynch divided a firm's P/E by its long-term growth rate to gauge value, and Valero's 10.6 P/E and 31.7-per-cent growth rate make for a strong 0.34 PEG (price-earnings to growth) ratio. The O'Shaughnessy approach likes its 0.22 PSR.
Disclosure: The writer is long VLO.
John Reese