The investor then sees these companies as opportunities for growth. This is also referred to as the intrinsic value of shares, or more precisely the intrinsic value of the traded company.
Various metrics are used. True value is determined by combining indicators such as the company’s financial performance, revenue, cash flow and profit. The business model, target market and competitive advantages are also taken into account. Let us look at the individual accounting indicators in more detail.
Founders of value investing
The founders of value investing are considered to be two economics professors, Benjamin Graham and David Dodd. Graham’s most famous book, The Intelligent Investor, still sells extremely well today. Graham’s students and followers also include the highly successful investor Warren Buffett, who built his company Berkshire Hathaway from nothing and still runs it. This 90-year-old investor largely demonstrates that, over the long term, this is a suitable and profitable way to invest.
The one-third rule
To begin with, here is one basic rule from Benjamin Graham himself. The founder of the theory states that a buying opportunity appears when a share is undervalued by at least one third.
P/B ratio (price-to-book)
This is the ratio of the share price to the book value per share. In other words, it is a multiple of the company’s capital that the investor buys through the share price. It primarily measures the value of assets. If the share price is lower than the value of the assets, the shares are undervalued, provided that the company is not in financial distress.
P/E ratio (price-to-earnings)
This is sometimes referred to as the P/E ratio. It is the ratio of the price to the company’s earnings. It shows returns, meaning whether the share price truly reflects the money the company has managed to earn. The P/E ratio generally varies significantly depending on the type of share, for example whether it is a technology company or a bank. It is important to monitor current recommendations for P/E levels, which are usually issued by certified investment advisers or banks.
Free cash flow
This is the cash that a company generates from the revenue of its business operations after deducting costs. This cash remains after all expenses have been paid, including operating costs and major purchases, known as capital expenditure.
In industrial conglomerates, this typically means buying machinery for production, or in the case of technology giants, for example patents. Generally speaking, if a company generates free cash flow, it has money left to invest in the future of the business, can repay its debts without difficulty, pays dividends and prospers.
Do not buy overvalued shares
We will conclude the detailed explanation of the individual rules with one general principle. Value investing is based on the idea that the investor does not buy “expensive” or even “overpriced” shares. However attractive today’s leading technology shares such as Tesla or Apple may look, they would fail most of the criteria, and Graham would certainly not buy them.
It is up to each investor to decide whether to prefer the gradual growth of a value portfolio or to favour the aggressive shares of the past two decades.
How to identify undervalued shares – comparing indicators
You can identify undervalued shares using the indicators we have already covered earlier in this article, such as P/E, P/B and others.
Compare indicators by sector
The key point is that each sector has different usual, or average, values for a given indicator. This means that a particular indicator may have, for example, a completely different usual, or average, level in banking than in the pharmaceutical industry.
Usual level of the P/E ratio
Below is a list of the sectors into which publicly traded companies are usually divided, together with the value of the P/E ratio. If a company remains below the stated threshold over the long term, it may, in combination with other indicators, be a good buy.
- Technology and IT: Technology companies usually have a higher P/E ratio, which may reach 20 or more. Example companies: Apple, Alphabet (Google).
- Financial sector: Banks and financial institutions may have a lower P/E, typically in the range of 10 to 15. Examples: JPMorgan Chase & Co (JPM), Bank of America (BAC).
- Healthcare: Healthcare companies may have a P/E of around 15 to 20. Example: UnitedHealth Group Incorporated (UNH).
- Energy: Energy companies, especially those focused on fossil fuels, may have a lower P/E ratio, often below 10. Example: ExxonMobil (XOM).
- Consumer goods: Companies in this sector may have a P/E in the range of 10 to 20. Examples: Procter & Gamble Company (PG), Coca-Cola (KO).
Usual level of the P/B ratio
Now we also provide a list for the P/B ratio (price-to-book). Again, a company may be suitable to buy if it is trading at a lower than usual P/B ratio. However, this should not be the only reason for buying the selected share.
- Technology and IT: Technology companies often have a higher P/B, which may reach values between 5 and 10, and in individual cases even higher.
- Financial sector: Banks and financial institutions usually have a P/B in the range of 1 to 2.
- Healthcare: Healthcare companies most often have a P/B of around 2 to 4.
- Energy: Energy companies usually have a P/B ratio of around 1 to 2, reflecting the value of their physical assets.
- Consumer goods: The consumer goods sector usually has a P/B ratio in the range of 2 to 4.
Look for high-quality companies that are not widely discussed
Another way to identify undervalued shares is to monitor the part of the stock market that is outside the main media spotlight. The media often favour coverage of popular companies, such as Apple, Microsoft and others. This means that lesser-known or generally smaller companies may go unnoticed and therefore lack long-term investor interest, which can lift share prices.
Investors should therefore gather information about companies that do not attract as much media attention. Where should you start? For example, investors can search using the list of companies in the US S&P 500 index and focus within it on companies that are less well known in the media.
However, do not forget that your research should include, for example, companies’ financial reports, their statements or expert analyses. It is not advisable to rely solely on the fact that a particular company is not being discussed in the media. The company must also appear suitable to buy based on other indicators.
Criticism of value investing
There are also critics of the entire theory. Since the last crisis of 2007 and 2008, value stocks have lagged the US stock market fairly significantly, with selected growth stocks in particular driving it higher. The clearest difference is seen in the so-called FAANG group, namely Facebook, Apple, Amazon, Netflix and Google (or, today, Alphabet). These stocks have a relatively large weighting in indices, so they lift the overall market.
Investors who defend the value approach often say that the sudden and very strong rise in growth stocks is not sustainable over the long term. From a historical perspective, for example when looking at the 20th century, they are right. The situation has changed roughly since 1995. This is probably due to the rapid rise of technology stocks. Some technology companies, whose market capitalisation is growing to enormous proportions, did not falter even after the technology bubble burst in 2001 and were not derailed by the crisis of 2008.
On the other hand, an investor should not spend a lifetime waiting for one major opportunity that may never arrive. Most advisers and investors agree that investing is a long-term matter and that everyone should gradually build their portfolio. As this year has shown, it is sometimes not a good idea to delay purchases, otherwise the proverbial train may leave without you. Some investors have been waiting in vain for a truly major fall in shares ever since the 2008 crisis.