As we kick off 2021, it’s inevitable that the financial media will discuss whether this will be the year for value investors. It’s been a lean decade or more for style investors that plant their flag on the value investing camp. However, it’s a new year and with it comes new opportunity. Let’s explore the three fundamental stock types and what specifically defines a value stock.
3 Fundamental Stock Types
When evaluating a company, there a stock will fall into one of three categories: growth, value or income. As a fundamental investor, it’s essential that you know which fundamental stock type the company you’re evaluating falls under. This is because each company is managed differently and has different opportunities from a business perspective and offer different things to prospective investors. Understanding how to evaluate the business and understanding what the company has to offer is critical.
Growth
A growth stock is defined by its ability to grow earnings and revenues. Sounds pretty simple and at times it may be pretty obvious. However, many times we confuse a company as a growth stock when it offers little growth opportunity. The best way to initially assess if a company is a growth stock is to look at the 3-year revenue and EPS growth to gain a historical perspective. Then, look at analyst projections for revenue and EPS in the coming years.
Value
A value stock probably most aligns with the principle of fundamental investing to buy stocks at a discount. While significant growth can make a stock look cheap today, there are other considerations to make about what a company is worth. One of the most common ways to evaluate a company is through valuation ratios that incorporate sales, EBITDA, book value, etc.
Income
An income stock is a company that pays a dividend. The dividend is measured in terms of yield and to buy a company for its dividend there are some basic criteria that should be considered. The first is that the yield is enough to warrant buying the company for its dividend. The second consideration is whether the company is generating sufficient cash flow to pay the dividend.
History of Growth vs. Value
In the chart below you’ll see a plot of the ratio of iShares MSCI USA Value Factor ETF (BATS: VLUE) and iShares MSCI USA Momentum Factor ETF (BATS: MTUM). These are large cap ETFs and iShares lists MTUM as a growth factor ETF. Since 2013, you’ll notice that the line has pretty much trended down with only brief respites. The biggest year for value investors compared to growth was 2016. However, the outperformance was fleeting.
This history gives a little perspective for those considering a value investing path exclusively. You may find yourself like Charlie Brown having the football pulled away from Lucy just as he’s ready to kick it. However, considering a company’s valuation is never a bad thing.
Evaluating Value Stocks
Frequently, value investors are bottom-up investors. That means that they have a set criterion that a company must meet to consider it. However, that doesn’t have to be the case. A top-down investor that is focused on sectors and industries that are expected to show strength can incorporate value criteria, just not as strictly. In that case, they are looking for the best value opportunity in an industry or sector.
Here is a set of criteria that may help you define a value stock:
- P/E < 5-year average or industry average
- Forward P/E < 15
- Price-to-book < 3
- Price-to-sales < 2
- PEG < 1
- EV/EBITDA < 10
This is a pretty strict standard and they typically are difficult to apply. However, we’re not in normal times in terms of valuation. In fact, the current valuation of the S&P 500 is near historic highs. The chart below is the Shiller P/E ratio for the S&P 500. The only time the index has been this highly valued was at the 2000 peak.
Because of the overextended nature of the market, it may create fewer value opportunities, but may help 2021 be the year of value Let’s take a look at each of the above criteria.
P/E
The price-to-earnings multiple is actually a difficult measure to set a standard for as a value investor. That’s because companies may attempt to make their earnings appear lower to reduce their tax burden. They may have a capital structure that may have more debt and higher interest expense. Another consideration is that the company’s growth prospects may impact the price that investors are willing to pay.
That being said, comparing the P/E of a company to its industry peers and, in particular, against the history of the company can provide the needed perspective. One shortcoming is that a company must produce positive GAAP net income to have a value.
Forward P/E
While P/E looks at what the company EPS in the trailing twelve months, Forward P/E takes into account what the EPS is projected to be next year. That means you’re comparing today’s share price with tomorrow’s earnings. This can help a company that is projected to grow its earnings quickly by normalizing its P/E to its earnings growth. This added factor allows you to have more of a set value to look for.
Price-to-Book (P/B)
So far, we’ve only looked at earnings as a measure, but it’s also important for value investors to consider the company’s net assets. The book value of a company takes the standard accounting equation of assets minus liabilities equals owner’s equity. The book value of the assets and liabilities makes up the net book value of the company. By dividing that cumulative value by the number of shares, you arrive at book value per share. By dividing price by that value, you arrive at how much you’re paying for the equity in the company.
Price-to-Sales
When a company doesn’t make money, value investors will have to turn to sales as a measure. Taking the price of the stock and dividing it by the revenue-per-share the company is making tells investors how much they are paying for every $1 of revenue.
PEG Ratio
The PEG ratio is one of my favorite measures and probably defines a value stock as much as anything. The ratio takes the P/E of a company and divides it by the 5-year projected growth rate of a company. Similar to forward P/E, the P/E is normalized to the growth prospects of the company. As a result, a higher growth company can justify a higher P/E and a lower growth company can’t. This also allows you to have a set standard for comparing companies.
EV/EBITDA
This ratio compares the enterprise value (EV) of a company against its earnings before interest, taxes, depreciation, and amortization (EBITDA). This removes some of the issues with EPS due to capital structure and decisions to reduce earnings for tax purposes. EBITDA is more comparable than EPS is. Also, EV incorporates the take-over value of the company. It includes the market cap plus the debt while subtracting the cash of the company.
Conclusion
As you move forward into 2021, hopefully this quick little guide to value investing helps you in your value investing journey. While the criteria can be strictly applied, it can also be used as a guide of what to look for when comparing companies. If we do get a corrections, it’s likely that value will outperform growth, but will also open the door to more opportunities as more companies are trading at better valuations.
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