Use Financial Ratios with Care – Not all Cheap Stocks are Undervalued


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30 June,2011

If you have been investing for any length of time, you have probably heard the term value investing. Perhaps, you also know that some of the most successful investors, such as Warren Buffett, Ben Graham, and John Templeton, are or were value investors.

What is Value Investing?

There is a fundamental principle in investing – Buy Low and Sell High. Do anything else, and you are certainly not making any profits. And like anything else that is so basic and common sense in life, this is also one of the most difficult principles to follow.

At any given point in time, how do you know that the stock price is low or high?

To answer this question, many finance practitioners and investors (and certainly media) tend to use some easy to calculate metrics called financial ratios. They than look back at these ratios through the history or compare it to some other common metrics to figure out what an average or a typical value ought to be. If the current Price ratio is lower than this value, the stock is deemed as potentially undervalued.

Two Common Financial Ratios and What to be Careful About

Some of the most common financial ratios that are being used today are Price to Earnings ratio (or P/E ratio) and Price to Book ratio (or P/B ratio).

P/E Ratio: A common rule of thumb is that if a stock is selling for a P/E ratio less than 15, than the stock is cheap. Why 15? Consider the inverse of a P/E ratio. This is called an Earnings yield. Essentially, this is the income that the company business generates per share in return for the price you paid for the share. If the company were to give back all the income to the shareholders, this is the return you will receive on your share of stock. A P/E ratio less than 15 implies an earnings yield of over 7% which is typically used as the average interest rate that one would receive on US Treasury bonds with zero risk.

The problems with the P/E ratio to find undervalued stock picks are many:

  • US Treasuries offer zero or almost zero risk – US government can and often does print more money to meet its obligations – to compare yields this way requires us to adjust for the increased risk of a corporate stock. Most risk in the business world arises due to uncertain future – so this is not easy to figure out.

  • Price is a “current” number while Earnings is a “historical” number. To use these two values to determine a stock’s attractiveness for investment (or a company’s future prospects) is a little bit like comparing apples and oranges.

  • Last 12 months of earnings may not reflect a true picture of the company’s current business – a high P/E ratio may be because the accounting earnings are temporarily low – perhaps due to an acquisition or a one time legal settlement. Similarly, a low P/E ratio may be due to an abnormally high earnings due to asset sales or some such one time events.

P/B Ratio: Price to Book ratio gives a little truer picture of a company’s valuation. Typically, a P/B of less than 1 is deemed attractive. Book Value refers to a company’s Asset Value minus Liabilities. Whatever is left over is the equity that a shareholder is entitled to if the company were to be broken up and market value of the assets were to be realized and the debt was paid off. If the stock is selling for less than this value, presumably the business is worth more in its net asset value alone, not to mention any earnings power it may have in its business.

  • Generally assets are carried on the book at cost and are depreciated (or amortized) based on some accounting principles or tax laws. This may make the asset book value different than the actual market value of such assets.

  • In fast moving industries such as electronics or computers, if the company uses Last in First Out (LIFO) inventory method for accounting, its inventory book value might be overstated if the prices have declined over the years. In industries that see rising prices, reverse will be true.

  • Certain intangible assets such as Goodwill may not be worth as much as it is carried on the books. Goodwill is typically the excess or the premium a company pays to acquire other companies. While they might believe that the premium is justified due to the acquired company’s market power, customer list, patent portfolio or some such intangible asset, once the acquisition is complete the value may not be there.

Bottomline: While these financial ratios do serve as an important screen to find potentially undervalued stocks, an investor still needs to review the underlying business to make sure that the ratios are usable. There is no alternative to careful due diligence in investing.

About the Author: Shailesh Kumar writes about value investing at Value Stock Guide and analyses and provides actionable value stock picks to his Premium clients. If you are looking for a reliable premium undervalued stocks alerts to beat the market in your stocks investments, then Shailesh’s premium service is the one to join.