This article was originally published here in May 2002
In my last article I showed you how to spot a good growth share. This time I am going to describe the financial ratios I use in my favourite form of investing, the value share. Buying value shares is one of the least glamorous ways of investing and yet it has given me my most consistent profits over the years.
Growth investors tend to concentrate on a company’s profit and loss statement. They look for companies which they predict will show strong profit growth over the next few years. An ideal growth share has little of the predicted growth factored into today’s share price. If the company’s profits do grow strongly then so will the price of the shares.
Value investors look to a company’s balance sheet. They try to find companies whose stock market value is below their own "true" value of the company. They buy the shares and wait for the gap between the stock market value and the company’s real value to close. It is akin to buying a pound for less than 100 pence.
Value investors make extensive use of financial ratios. These are simple to calculate but are a powerful investing tool. Their greatest use is in comparing similar companies. If the ratios show one company’s share to be cheap compared to its peers then spend some time to find out why. Often there is a good reason for the company’s share price to be depressed but occasionally you will find a share that the market is mispricing. Buy these shares and wait for the market to come to its senses.
The simplest ratio to use is the dividend yield, effectively the rate of interest being paid to shareholders. Mature companies tend to generate large amounts of cash that they pass onto their shareholders in the form of dividends. If the market thinks the company might be getting into difficulties the share price will drop, increasing the dividend yield. The company may really get into trouble and be forced to cut the dividend or the market will be proved wrong, the dividend will be maintained and the share price will increase to reduce the dividend back to the same level as other similar companies. This increase in the share price produces a nice capital gain and any dividend that you receive while you wait is a bonus.
The Price/Earnings ratio is also easy to calculate. It is often printed in the financial pages making comparison between companies in the same sector a doddle. My rough rule of thumb with the P/E ratio is that any share with a P/E below 10 is worth investigating as a possible value share. However, remember that it is not the absolute P/E of a share that’s important. What matters is the P/E of a share relative to similar companies. Look out for a share with a P/E ratio significantly below those of its peers.
The ratio that I feel is the most useful is the Price to Book Value ratio, abbreviated to P/BV. This is the market capitalisation of a company divided by the net value of the company’s assets. I prefer to use a variation of the ratio called the Price to Tangible Book Value ratio, shortened to P/TBV. This ratio ignores any intangible assets of a company. These assets can include things like the value of any trademarks and other intellectual property the company owns. More often intangible assets are just "goodwill", an accounting device use to keep the balance sheet in order after a company takes over another. Tangible assets are "real" in the sense they are the things a company owns, its stocks and any cash it might have.
If you look at a balance sheet in a company’s annual report you will see it broken up into sections. The table below shows the "good" and "bad" forms of assets and what they are. Balance sheets often use different names for these items and it can be confusing to work out what is what. As a clue "good" assets are often listed first and "bad" assets are shown as negative numbers. One accounting convention you need to know is that negative numbers are usually shown as a number in brackets.
| Good | Fixed Assets | The land, buildings and machinery a company owns. |
| Fixed Investments | The value of any Joint Ventures the company has entered into. | |
| Stocks | The value of any materials used to make goods plus the value of any finished but unsold goods. | |
| Debtors | Money owed to the company. | |
| Cash | Money the company has in the bank or in short term investments. | |
| Bad | Short term creditors | Money that the company owes to its suppliers or as a overdraft at the bank. |
| Long term creditors | Money that the company had borrowed over a longer period, either as a loan from a bank or by issuing bonds. | |
| Preference shares and minorities | Other forms of shares that the company may have issued. These usually rank higher than the ordinary shares and have the first claim on assets. |
Simply add together all the "good" assets then subtract the "bad" assets and divide it into the market capitalisation. If you finish with a negative number then run away. The company’s liabilities exceed its assets which is a very bad sign. If you end up with a large positive number the share is not a value share; the stock market valuation exceeds the value of the assets by too large a margin for comfort.
If the Price to Tangible Book ratio has a value near to or less than one the stock market may be undervaluing the company. Such companies deserve further investigation.
In conclusion; if you find a company who has a higher dividend yield, lower P/E and P/TBV in comparison to its peers then you might have found an excellent value share. On the other hand, you might have found a company in serious trouble. Spotting the difference is the trick.
Next month I will show my value share rules in action and how they led me to a recent investment.