Today we’ll be talking about Value Investing. What it is, how it works, examples of value investments and, most importantly, how you can utilise the value investing methodology in order to improve your portfolio performance.
I hope you enjoy reading and, as always, let me know any questions or comments below in the comments section.
Table of Contents
- The 3 main investment types
- What is Value Investing
- A theoretical example
- Important KPIs for Value Investing
- P/E Ratio
- P/B Ratio
- P/3Y-H Ratio
- When to buy and when to sell
- Examples of value investing
- How to find opportunities for value investing
- 1. Use a stock screener
- 2. Get more information for the stock
- 3. Pull all information together and make an informed investment decision
The 3 main investment types
There are 3 main investment types, which I will elaborate further on this blog: Value Investing, Growth Investing and Income Investing.
All 3 have their place in a well thought after portfolio. There is no best and worst type, but all 3 have the ability to create tremendous returns if done right.
How to distinguish the 3 types in short is explained below.
|Investment Type||Value Investing||Growth Investing||Income Investing|
|Methodology||Buy undervalued stocks and sell once back in line with valuation||Buy stocks which are growing tremendously and show no signs of a slowdown||Buy stocks with high dividend yield, so that the quarterly or annual dividend can either be used to re-invest or spent on expenses as a substitute for a regular income (e.g. from a job)|
|Main KPIs||P/E Ratio: the lower the better. Depending on the industry we’re looking at P/E ratios below 20, certainly lower than the industry average)|
P/B Ratio: < 1 (means Market Cap < Total Equity)
P/3Y-H Ratio: > 40% discount of current price vs the 3-year-high price
|Revenue: Rising revenues over the last 3-5 years|
Profit: Rising profits over the last 3-5 years
Total Equity: Rising total equity over the last 3-5 years, means assets increasing and/or liabilities decreasing
Price: Rising share price over the last 3-5 years
|Revenue: Rising or stable revenues over the last 3-5 years|
Profit: Rising or stable profits over the last 3-5 years
Total Equity: Rising or stable total equity over the last 3-5 years, means assets increasing and/or liabilities decreasing
Price: Rising or stable share price over the last 3-5 years
Dividend Yield: Rising or stable dividend yield, typically between 3% and 10%
|Example||Kier Group PLC|
P/E Ratio: 0.97
P/B Ratio: 0.25
P/3Y-H Ratio: -92% (Current Price: 105.9; 3Y High: 1473 (Mar-17) )
|AB Dynamics PLC|
Revenue: Increase from £13.85m (2014) to £37.05m (2018)
Profit: Increase from £2.65m (2014) to £7.88m (2018)
Total Equity: Increase from £10.33m (2014) to £38.04m (2018)
Price: Increase from 168 (Jan-2014) to 2713 (May-19)
|Royal Dutch Shell PLC|
Revenue: Stable; £421b (2014); £388b (2018)
Profit: Increase from £19b (2014) to £35b (2018)
Total Equity: Increase from £172b (2014) to £202b (2018)
Price: Stable; 2263 (Jan-2014); 2603 (July-19)
Dividend Yield: 5.5%
What is Value Investing
In essence, the value investor searches for companies trading at a price below the intrinsic book value of the company.
Therefore, for the value investor, it is important to understand the difference between the price of a company and its real value. While it is easy to assess the price of a company – the stock market shows prices for listed companies in real-time – valuing companies is a much more complex process.
One could argue the share price of a company and its value should in theory match, however usually the market overreacts to good and bad news, resulting in stock price movements that do not match with the companies intrinsic value.
A theoretical example
Company A is trading on the stock market for 200.00p, with 100m total shares, that results in a market cap of £200m. We assume that this is a fairly accurate estimate for the intrinsic value of the company at that time.
Now the company releases bad news, for example, profit warnings or missed revenue projections, which may have a long-term impact on the company’s value, let’s say 10%. This brings us to a new intrinsic value of £180m. The market, however, reacts badly to the news and the share price falls 20% on the day of the news being released. The new share price is now at 160.00p, which brings the market cap down to £160m. We now have a GAP between the intrinsic value of the company and its share price, which is the opportunity value investors are looking for. The larger the GAP between the two values, the higher the potential returns.
Warren Buffet and Benjamin Graham (Buffet’s professor and mentor) are probably the two best known value investors of modern times.
Important KPIs for Value Investing
In order to find companies suitable for the value investment approach, we need to look at a few fundamental KPIs, which help us to determine if a company trades above, in line or below its intrinsic value. The most important ones are discussed below.
P/E ratio stands for price-to-earnings ratio and measures the current share price of a company to its per-share earnings.
The P/E ratio is often used by investors as an indicator for a company’s price against its intrinsic value. Generally, a higher P/E ratio means that a company is either overvalued or higher growth is anticipated in the future. A lower P/E ratio may indicate an undervalued company or a company with slower growth in the future.
It is always important to compare the P/E ratio of a company with the industry average, however, the average market P/E ratio is roughly 20 times earnings, which can be used as a quick & simple reference.
Note that the P/E ratio can only be calculated for companies making a profit – companies making a loss do not have a P/E ratio.
For the value investing principle, we’re looking for a small P/E ratio compared to the industry average, e.g. if an industry has an average P/E ratio of 25, we’re looking for a company’s P/E ratio of below 15.
P/B ratio stands for price-to-book ratio and measures the current share price of a company to its book value per share.
A company’s book value is equal to its bottom line balance sheet value. This means the sum of total assets minus liabilities, also sometimes referred to as Net Assets or Total Equity. In other words, if a company liquidated all of its assets and paid off all its debt, the value remaining would be the company’s book value. That means if we buy a company (or shares of a company) below its book value, we are still making a profit, even if we were to shut down the operations of the company.
Now it also sounds sensible, that most healthy companies turning over a stable profit with limited debt, trading at a market price much higher than its book value.
If a company’s P/B ratio is exactly 1, this means that its market price matches its current intrinsic value. A lower P/B ratio indicates a company is undervalued.
The simplicity of this indicator makes it perfect to use for the value investing principle, where we’re typically looking for companies with a P/B ratio of smaller than 1. E.g a company with a price-to-book ratio of 0.5 has a 100% growth potential vs the current price until it only reaches a 1:1 P/B ratio.
Once we have discovered a company with a P/E and P/B ratio fitting our requirements, the next indicator I typically analyse is the price-to-3-year-high ratio.
With the P/3Y-H ratio, we calculate the discount of a company’s current market price vs it’s highest price over the past 3 years, which is an indicator of technical analysis rather than fundamental.
For the value investing principle we typically look for companies with a discount higher than 40% to have a sufficient margin of safety applied.
Companies with P/E and P/B ratios within our expectations, however not trading at a discounted price vs the past 3 years, may need much longer until the P/E and P/B ratios are in line with their industry average and require probably a series of good news.
On the other hand, companies which crash sold 40%, 50% or sometimes even 90% over a short period of time due to bad news and then trading with a P/E ratio of far below industry average and a P/B ratio of far below 1, usually just need some good news or large investor to reverse the downtrend.
When to buy and when to sell
Given our indicators, as discussed above, we can build a simple system for our value investing methodology.
We buy companies with the following set-up:
- P/E ratio below the industry average, typically below 20
- P/B ratio below 1
- P/3Y-H ratio greater than 40%
As value investing is mostly a fundamental principle, we don’t necessarily need to wait for certain technical events to happen, but can invest immediately.
Along the way up we can simply add to our position as long as the above set-up is still valid. I typically add whenever key levels like previous resistances or whole price values are broken.
Once the described set-up is no longer valid, we stop adding to our position and prepare to sell and take our profits. At the latest, we prepare to sell once the company approaches the 3-year-high-price. To apply a margin of safety, I usually sell once my investment has reached 90% of the 3-year-high-price.
Examples of value investing
One of the value investments in my current portfolio is Kier Group PLC.
In July 2019 we’re currently looking at the following set-up:
- P/E Ratio: 0.91 (Industry average of Construction & Engineering: 11.4)
- P/B Ratio: 0.24
- P/3Y-H Ratio: -93% (Price Jul-17: 105.9; 3Y High: 1473 (Mar-17) )
A P/B ratio of 1 would be achieved at a price of 441, while the P/E ratio would fall in line with the industry average of 11.4 at a price of 1221.
We’re setting the target at 90% of 3Y High, which gives us a target of 1300, however, we average this down by using a broker target of 320, which leads to our final target of 820, a staggering 674% increase vs the current price.
Along the way, I’ll add to my position at price points of 200, 300 and 400. After that, I’ll stop adding as the P/B ratio likely breaks above 1 and I prepare to sell at my target price of 820.
How to find opportunities for value investing
Now that you know what value investments are, all you need to know is, how to find value investment opportunities in the market.
Here’s how I’m scanning the market for opportunities and assessing them accordingly to the discussed methodology.
1. Use a stock screener
First, I use a stock screener to find stocks with a P/B ratio < 1. I usually scan the market by industry or simply look up stocks I read about in the news or magazines.
For that purpose I use the screener from trading view: https://uk.tradingview.com/screener/
There, I built a simple screener showing fundamental data as shown in the screenshot below: Ticker Name, Last Price, Market Cap, Assets, Debt, P/B Ratio, P/E Ratio, Dividend Per Share, Total Shares and Industry.
It is free to use, but you can go Pro, if you want to export the data, have more timeframes available and get the screener to auto-refresh. With the Pro version there are a lot of other benefits as well, see a full breakdown here: uk.tradingview.com/gopro/
2. Get more information for the stock
Once I discovered a suitable stock with an interesting P/B ratio, the next step is to analyse more data, especially the P/E ratio and P/3Y-H ratio. While the screener at tradingview shows P/E ratios, I don’t 100% trust that data, hence I go to Hargreaves Lansdown (HL) for any further, more detailed analysis: hl.co.uk/shares
HL provides a lot of information about a particular stock, amongst others Charts & Performance, News, Broker Forecasts, Financials and Dividends.
I’m most interested in the P/E Ratio and Dividend Yield at this stage as well as any broker forecasts. I also have a look on the Financials tab, where I can view annual and interim reports as well as the balance sheet over the past 5 years. This is to ensure the company has healthy fundamental numbers.
3. Pull all information together and make an informed investment decision
Finally, we need to pull all the gathered information together to make our informed investment decision.
For this purpose, I developed an Excel tool, which is illustrated in the screenshot below.
I enter the stock I want to analyse into the tool and it automatically pulls the historical performance data as well as current Bid and Ask Price. It also calculates the P/3Y-H ratio. We fill in the collected data, like the broker targets, P/B ratio, Dividend Yield and P/E ratio.
The tool will then calculate the potential for profit if invested at the current price and sold at the target price. As a rule of thumb, I’m currently looking for profit potentials of at least 40%, in order to have a large enough margin of safety, in case the investment doesn’t play out as anticipated.
If you are interested in this tool, please contact me on [email protected] or drop me a message on social (see buttons below).
This is how to utilise Value Investing as an Investment Strategy for your Portfolio. I hope you enjoyed reading this article and let me in the comments below if you are utilising this method in your investment portfolio and how this works out for you.
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