Value investors use stock metrics to help them uncover stocks they believe the market has undervalued.聽Investors who use this strategy believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with a company's long-term聽fundamentals, giving investors an opportunity to profit when the price is deflated.

Although聽there's no "right way" to analyze a stock, value investors聽turn to聽financial ratios聽to聽help analyze a company's fundamentals. In this article, we'll outline a few of the most popular financial metrics used by value investors.聽

Key Takeaways

  • Value investing is a strategy for identifying undervalued stocks based on fundamental analysis.
  • Berkshire Hathaway leader Warren Buffett is perhaps the most well-known value investor.
  • Value investors use financial ratios such as price-to-earnings, price-to-book, debt-to-equity, and price/earnings-to-growth to discover undervalued stocks.
  • Free cash flow is a stock metric showing how much cash a company has after deducting operating expenses and capital expenditures.

Price-to-Earnings Ratio

The price-to-earnings ratio (P/E ratio) is a metric that helps investors determine聽the market value of a stock compared to the聽company's聽earnings. In short, the P/E聽ratio shows what the market is willing to pay today for a stock based on its past or future聽earnings.

The P/E ratio is important because it provides a measuring stick for comparing whether聽a stock is聽overvalued聽or聽undervalued. A high P/E ratio could mean that a stock's price is expensive relative to earnings and possibly overvalued. Conversely, a low P/E ratio might indicate that the current stock price is cheap relative to earnings.

Since the ratio determines how much an investor would have to pay for each dollar in return,聽a聽stock with a lower P/E ratio relative to companies in its聽industry聽costs less per share for the same level of聽financial performance聽than one with a higher P/E ratio. Value investors can use the P/E ratio to help find undervalued stocks.聽

Please keep in mind that with the P/E ratio,聽there are some limitations. A company's earnings are based on either historical earnings or forward earnings, which聽are based on the opinions of Wall Street聽analysts. As a result,聽earnings can be hard to predict since past earnings don't guarantee future results and analysts'聽expectations can prove to be wrong. Also, the P/E ratio doesn't factor in earnings聽growth, but we'll address聽that limitation with the PEG ratio later in this article.

P/E ratios are useful for comparing companies within the same industry, not companies in different industries.

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5 Must-Have Metrics For Value Investors

Price-to-Book Ratio

The price-to-book ratio or P/B ratio聽measures聽whether a聽stock聽is over or undervalued by comparing the net value (assets - liabilities) of a company to its market capitalization. Essentially, the P/B ratio divides a stock's share price by its book value per share (BVPS). The P/B ratio is a聽good indication of what investors are willing to pay聽for each dollar of a company's net value.

The reason the ratio is important to value investors is that it shows the difference between聽the market value of a company's stock and its book value. The market value is the price investors are willing to pay for the stock based on expected future earnings. However, the book value is derived from a company's net value and is a more conservative measure of a聽company's worth.

A P/B ratio of聽0.95, 1, or 1.1 means the underlying stock is trading聽at nearly book value. In other words, the P/B ratio is more useful聽the greater the number differs from 1. To a value-seeking investor, a company that trades for a聽P/B ratio of 0.5 is attractive because it implies that the market value is one-half of the company's stated book value.聽Value investors聽often like to seek out companies with a market value less than its book value聽in hopes that the market聽perception turns out to聽be wrong. By understanding the differences between market value and book value, investors can help pinpoint investment opportunities.

Debt-to-Equity Ratio

The debt-to-equity ratio聽(D/E) is a stock metric that helps investors determine how a company finances its assets. The ratio shows聽the proportion of equity to聽debt a company聽is using to finance its assets.

A low debt-to-equity ratio means the company uses聽a lower amount of debt for financing versus shareholder equity. A聽high debt-equity ratio means聽the company derives more of its financing from debt聽relative to equity. Too much debt can pose a risk to a聽company if they don't have the earnings or聽cash flow to meet its debt obligations.聽

As with the previous ratios, the debt-to-equity ratio聽can vary from industry to industry.聽A high debt-to-equity聽ratio doesn't necessarily mean the company is run poorly.聽Often,聽debt is used聽to expand operations聽and generate additional streams of聽income. Some industries with a lot of fixed assets, such as the auto and construction industries, typically have higher ratios than companies in other industries.聽

Free Cash Flow

Free cash flow聽(FCF) is the cash produced by a company聽through its operations, minus the聽cost of expenditures. In other words, free cash flow is the cash left over after a company聽pays for聽its operating expenses聽and capital expenditures (CapEx).

Free cash flow聽shows how efficient a company is聽at generating cash and is an important metric in determining聽whether a company has sufficient聽cash,聽after funding operations and capital expenditures, to reward shareholders through dividends and share buybacks.

Free cash flow can be an early indicator to value investors that earnings may increase in the future, since increasing聽free cash flow typically precedes聽increased earnings. If a company has rising FCF, it could be due to revenue and sales growth, or聽cost reductions. In other words, rising free cash flows could reward investors in the future, which聽is why many investors cherish free cash flow as a measure of value. When a company's聽share price is low and free cash flow is on the rise, the odds are good that earnings and the value of the聽shares will soon be heading up.

PEG Ratio

The price/earnings-to-growth (PEG) ratio聽is a modified version of the P/E ratio that also takes earnings growth into account. The P/E ratio聽doesn't always tell you whether or not the ratio is appropriate for聽the company's forecasted growth rate.聽

The PEG ratio measures the relationship between the price/earnings ratio聽and earnings growth. The PEG ratio provides a聽more complete picture of whether a stock's price聽is聽overvalued or undervalued聽by analyzing both聽today's聽earnings and the expected聽growth rate.聽

Typically a stock with a聽PEG of less than 1 is considered undervalued since its price is low compared to the company's聽expected聽earnings growth. A PEG greater than聽1 might be considered overvalued since it might indicate the stock price is too high聽compared to the company's聽expected earnings growth.聽

Since the P/E ratio doesn't include future earnings growth, the PEG ratio provides a more complete picture of聽a stock's聽valuation. The PEG ratio聽is an important聽metric for value聽investors since it provides a forward-looking perspective.聽

The Bottom Line

No single stock metric can determine with 100% certainty whether a stock is a value or not. The basic premise of value investing is to purchase quality companies at a good price and hold onto these stocks for the long-term. Many value investors believe they can do just that by combining several ratios to form a more comprehensive view of a聽company's financials, its earnings, and its stock valuation.聽