VALUE INVESTING - BASICS

Value investing is an important tool in the arsenal of a fundamental investor. In simple terms it means buying a stock for much less than what an investor thinks it is worth. But how does a value investor decide the worth of the company under study? Given below is an explanation of some basic parameters to decide whether a business is undervalued or not. They are

1. PE ratio. This is the ratio of the market price of a stock to its earnings per share. It also the number of years the business will take to realise earnings equivalent to the current market price based on current earnings. For instance a business having a PE ratio of 10 would take 10 years before its earnings behind one share equals the market price of one share. This, of course, assumes that the company will keep on earning the same amount of profits every year. PE ratio, therefore indicates how expensive a company is based on current earnings. This is a useful indicator to compare companies in a similar line of business. Lower the PE ratio, cheaper is the stock. Naturally, PE comparisons cannot be carried out across industries, because some industries are given higher PE ratios due to their business dynamics.
2. Market Capitalisation. The market cap of a business is the number of shares outstanding multiplied by the price of each share. In short the market cap denotes the notional cost of buying the entire shares of the company. This parameter is useful in judging the relative attractiveness of a business as compared to other businesses in similar lines based on what value the market has assigned that business by way of market cap. For example a business in the consumer durable sector may be valued at significantly lower market cap than another consumer durable company. This would make it a value buy based on market capitalisation. For more on how to value a business based on market cap refer here.
3. Book Value. Book value is value of assets of the company behind every share. It represents the valuation of the stock based on its underlying assets rather than its earnings. If the market price of a stock is quoting at or below its book value, it means that the market does not think that the prospects of that company are bright and often indicates that the company that has become insolvent. However if the market price is below book value due to factors of a temporary nature, then this fact can be looked at by investors as a value proposition and can be used to buy into the stock with a holding perspective till the negative factors turn around.
4. Dividends. A value investor uses the dividend payouts as an important factor to determine undervaluation in a stock. If the dividend yield of a stock (i.e. the dividend per share divided by the market price) is high it indicates a higher degree of safety in times of adverse market conditions. Also important is to see what proportion of its earnings a company pays out in the form of dividends. For more on use of dividend yields referhere
5. Net current assets. Net current assets (NCA) are current assets minus current liabilities. If a business has high net current assets and the markets are assigning it a market cap near or below its NCA, it indicates a high degree of undervaluation. According to Benjamin Graham, the pioneer of value investing, investors cannot often go wrong in buying a business valued at or below NCA.

   The above are basic factors used by value investors in determining the relative underperformance of a stock. Of course, an investor also needs to go into the reasons as to why the market is giving a significantly lower valuation to a stock or an entire industry and whether it is justified in doing so before taking an investment decision.