I reckon one of the best chances of finding shares that go on to perform well is to focus on the underlying quality of the business. But after you’ve done that, you can increase the probability of a successful investment outcome by looking for good value as well.
Super-performing investor Warren Buffett once said, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
Cheap stocks tend to outperform expensive stocks for their shareholders – not always, but studies have shown that it happens often enough to make hunting for good value worth all the effort.
Valuation must-have tools
We can use several indicators to uncover value. One of the most well-known is the price-to-earnings ratio, or earnings multiple as it is sometimes called. It divides the share price by the figure for annual earnings per share to come up with a single number, such as 12, for example. The higher the number, the more expensive the stock when measured against earnings.
Then there’s the dividend yield, which divides the annual dividend per share figure by the share price. That calculation usually comes up with a decimal fraction and if you multiply it by 100 you can express it as a percentage, such as 5%, for example. The higher the percentage, the cheaper the stock compared to the dividend.
Those two measures are straightforward and universal to all stocks. Others require greater interpretation, such as the price-to-sales ratio. To find that, you just divide the market capitalisation by the annual revenue figure. Tesco, for example, is running at about 0.35. However, supermarkets shift loads of stock and make a tiny profit on each item, so that figure doesn’t necessarily mean the shares are selling cheap.
Indeed, firms in other sectors can look quite different when it comes to the price-to-sales ratio. BT, for example, throws out a figure of about 0.83 right now, but BT arguably looks cheaper than Tesco when measured against other indicators. And GlaxoSmithKline has a figure around 2.6. I reckon it’s important to compare the price-to-sales rating of a firm against other companies in the same sector and to use the measure in conjunction with other value indicators.
It’s a similar story with indicators such as the price-to-asset (or book) value and price-to-free cash flow. They are useful tools, but not in isolation and not without comparison.
Avoiding low-valuation losers
Valuation is an important step in finding shares that will go on to perform well for shareholders, but don’t get carried away with it. I reckon it always pays to remember that we are looking for good quality stocks selling as cheaply as possible and not just cheap stocks.
It’s worth bearing in mind that companies with low-quality businesses, or those in a distressed state, often throw up the cheapest-looking valuation indicators. But you wouldn’t want to touch them with a bargepole, in my view.
Quality stocks will probably never show you very low valuation measures, but they will likely appear at fair prices from time to time, and those are the best times to pounce if they are to help you make a million.
