In an era where many investors are racing after the latest trending stocks or trying their luck with the short-term waves of the market, value investing might seem a bit bland. However, some of the most accomplished investors in the world are ardent supporters of this approach.
What sets value investing apart is its foundation in plain old common sense. The essence of this strategy is straightforward: purchase shares of robust businesses for less than what they’re truly worth. This not only reduces the risk on the downside, but when the market ultimately acknowledges the company’s true value, patient investors can enjoy significant returns.
But don’t let the simplicity deceive you into thinking it’s easy.
To excel in value investing, one needs to think independently, carry out thorough research, and possess the discipline to ignore the noise of the crowd. Hence, having a clear, objective framework is crucial to pinpointing real deals amidst the market chaos.
As the chief of Wealthy Retirement’s Value Meter column, my goal has been to assist readers in evaluating whether stocks are overvalued or undervalued without making it overwhelmingly complex.
Ben Graham, the godfather of value investing, believed financial analysis should be uncomplicated, relying on nothing more than basic math. Though our Value Meter involves a bit more complexity than simple arithmetic, it still strives for simplicity with just three key metrics.
The Value Meter Criteria
Let’s start with the first vital metric that defines a good business: its ability to generate profits. So, what’s the finest indicator of profitability?
Reported earnings can often be deceitful. Large one-time gains, changing accounting methods, and managerial manipulations can all paint a misleading picture of a company’s true profitability. That’s why most value investors focus on cash flow instead.
Free cash flow is the primary, though not the sole, profitability measure I examine. It signifies the cash a company makes after deducting operating and capital expenses.
Consistent cash flow is the heartbeat of any business because it empowers the company to grow, lower debt, and reward shareholders.
After evaluating a company’s free cash flow, I then compare it with the company’s net asset value (NAV), which is the difference between its assets and liabilities. This helps me assess how well the company is using its assets to generate cash flow.
The higher the free cash flow to NAV ratio, the better.
Consider, for instance, Company ABC and Company DEF, both with $10 billion in net assets. If Company ABC generates $40 billion in free cash flow while Company DEF manages only $20 billion, Company ABC is twice as proficient as Company DEF in converting assets into cash.
By calculating this ratio over the past four quarters for each company, I can determine where each stands among approximately 6,000 U.S. exchange-traded stocks in my database.
The third key metric is the total hypothetical cost of buying the entire business, known as enterprise value, or EV. Unlike market capitalization, EV includes the entire acquisition cost, both equity and debt.
Similar to how I handle free cash flow, I compare each company’s EV with its NAV. A low EV/NAV ratio implies a relatively low cost to acquire the company, a hallmark of an undervalued stock. The lower the figure, the better.
Finally, I score each company by averaging its rank for each metric and using basic statistical analysis to assign a rating on a scale from 0 to 6. These scores fall into five categories: “Extremely Undervalued,” “Slightly Undervalued,” “Appropriately Valued,” “Slightly Overvalued,” and “Extremely Overvalued.”
At the end of each Value Meter column, you’ll find all this data compiled into a simple graphic. Here’s an example:
Overall, my Value Meter system favors businesses that produce high cash levels compared to their net assets while being traded at low EVs. If a company excels in both, it denotes that it’s more efficient and less expensive than its peers.
Admittedly, my system isn’t without its drawbacks.
It obviously favors asset-heavy companies with substantial free cash flows, which tend to be mature businesses rather than those in the initial growth stages. This means it may not rate fast-growing, capital-light firms positively, some of which could be spectacular investments. Many growth-centered investors might view this as a major flaw.
Nonetheless, for those on the hunt for a straightforward method to spot undervalued companies, The Value Meter provides a solid foundation. Focusing unwaveringly on cash generation and asset value can aid investors in staying grounded.
Value investing isn’t the sole route to amassing wealth in the market, but over the decades, it has demonstrated its worth. The Value Meter aims to make this timeless strategy more accessible than ever.
If you have any questions about my Value Meter system, or if you want a particular stock to go through The Value Meter, feel free to leave a comment below.
