What do Value Investors Look for in Stocks?

What factors should you consider when evaluating a value stock? Before we answer that question, maybe we should briefly define value investing.

Value investing is finding a stock that is selling at a discount to its intrinsic value or companies that the market has undervalued for some reason unrelated to its economic fundamentals.

Benjamin Graham pioneered the value-investing concept and recognized the biggest flaw in the strategy: deciding what a company’s intrinsic value is.

Margin of Safety

For this reason he always counseled for a margin of safety that provided room should your calculation of the intrinsic value be off.

This is important because the key to successful value investing is buying at the correct price. Graham’s strategy called for a strict discipline on price, which included his margin of safety.

If he could not buy the stock at that price, he would pass.

Many modern stock pickers scoff at the rigidity of his system, yet Graham and his pupils, such as Warren Buffett, have made fortunes sticking to the strategy.

Financial Statistics

Here are some of the financial statistics value investors study, historical and forward:

• price to book ratios
• price to sales ratios
• price to earnings ratios
• price to cash flow ratios

For an explanation of these ratios, see Tools of Financial Analysis.

The value investor will look for these ratios to be below the S&P 500 benchmarks for a company’s industry group.

However, let’s be clear. Value investors are not looking for companies on the way to bankruptcy. They are looking for companies that have been beaten up by the market for no real fault of their own.

One of the ways you can make sure the company is on solid footing is to look at its financials.

Debt Ratios

Look in particular at its debt ratios (debt levels should be low) and look for good cash flow. A company with manageable debt and good cash flow is worth getting to know better, regardless of how the market is treating the stock.

How does a good company become a value stock? Several things can happen.

• The company may not have a glamorous product. Some products just don’t get much attention, but still must be produced, for example, those orange barrels you see on highway construction sites.
• The growth prospects for the stock may not be high relative to other opportunities in the market. During the dot.com stock frenzy of the late 1990s, almost any stock that wasn’t high tech became a value stock in comparison.
• If a stock is selling at below $15 - $20, some investors think there must be something wrong with the company. This is an irrational response, but it happens.

Conclusion

Successful value investing depends on identifying a stock that is trading under the intrinsic value of the company and buying with a margin of safety in case you have misjudged the intrinsic value.