The purpose of the value investing strategy is not to find the best performing companies (no one is able to), but rather to take advantage of the upgoing trend that the market has to offer over the long term, while taking the least possible risk investing only in companies trading under their intrinsic value.
An analyst will always think in terms of value and not in terms of price or results. The notion of value integrates many more parameters, which go way beyond the purely financial analysis of the company itself. It is this concept of value that is creating the gap between the price of a company's share on the stock market and the economic price of the same company.
On stock markets, investors can make decisions for several reasons: because they think the company’s market is expanding, because the management board innovates, federates smart people and has ambitions for greater results, because they have proven on several occasions that they are able to achieve those objectives, because everyone is talking about it etc. But how do they manage to understand if the price they are paying is fair ?
We can have a good idea or at least an order of magnitude of the economic value of a company. All you have to do is calculate its net assets from its balance sheet. Take the total value of the assets minus the amount of its debts and provisions. Consider that you take what the company owns and subtract what it owes. If you know how a balance sheet is implemented, then you understand that the result you should get is equivalent to the amount of equity. But in some businesses, mining for example, this calculation requires a more detailed treatment of assets, and sometimes, it leads to considering that most of them are worthless because they are not liquid, i.e. impossible to convert into cash within a reasonable time. This is where the expertise comes in.
Whatever the result of your calculation is, you will notice that there is always a significant gap between a company's equity and its stock market value.
As mentioned, on stock markets, investors may be willing to pay much more than the net assets per share to acquire a stock. They often try to calculate the intrinsic value of the company, using various models, including the DCF. In this concept of value, they will therefore take into account the future cash flows of the company, which seems to make sense. In fact, if you're looking to buy a business next door, you're expecting to increase the performance of that business, and if you know, before making any decision, that it's impossible, of course you will back out.
Intrinsic value, economic price, net assets, equity... It's a lot of stuff ! But believe me, being aware of the meaning of those different concepts will certainly allow you to make better decisions and to stop listening to your neighbor to know which stock to buy tomorrow.
So, using a value strategy means calculating the intrinsic value of a company (or at least reading analysis from others) and checking that it is lower than the market value? Well, no. Not quite.
Respecting the margin of safety is only one step in the process, it's the minimum you can do. A stock is often protected by its intrinsic value, but it is also attracted by it. It oscillates around it and evolves more or less at the same rhythm as it, with times of variable amplitude, up or down. You then understand that buying an undervalued company allows you to take less risk. However, be careful, do not try to catch a falling knife! A company can be undervalued for many reasons. This is where the value investor can express his experience.
In fact, beyond verifying that the company is indeed undervalued, the smart investor will also check the financial structure of this same company. He needs to diagnose it and determine whether or not it is in good health. Being in good health means, first of all, having positive equity (the company did not accumulate too many bad years in a row) and then being able to pay back its liabilities in due time. The analyst will therefore start by looking at the credit rating given to the company by the rating agencies, this assessment determines the rate at which the company borrows money. To give this rating, Moody's, Fitch or S&P focus on the proportion of debt to equity, its liquidity, the value of its assets, the type of assets involved, the creditworthiness of its partners, etc. But as the intelligent investor does not fully trust these rating agencies and their opaque evaluation, he will also do his own work by adding his experience and his convictions.
Value investing requires a lot of experience.
And we understand why it takes several months to study a company before making any decision. For the individual investor like you and me, there are few tips that we can use.
Start by looking at the company's PBR. Its Price to Book Ratio. That is to say the comparison of the capitalization of the company to its net assets, its economic value. Use this ratio (or multiple) as a comparison tool. Ratios do not allow you to do a quantitative analysis, but a comparative analysis. Look at other companies in the same business field, in the same kind of industry. Take a relatively large number of companies, the statistics are meaningless unless the sample is large enough. For example, it would be foolish to use only Tesla and Ford to analyze the automotive sector in the US.
If the PBR is higher than 1, it does not necessarily mean that the company is overvalued. As mentioned earlier, there is a difference between intrinsic value and net assets. But if the PBR is under 1, then you have a good chance that the company is undervalued. That's good news for you, if you make sure that the company's earnings have not been in free fall for several years with no apparent recovery.
You can then look at the company's capitalization and compare it to its turnover. This is a very good indicator, but once again, the orders of magnitude can vary significantly from an industry to another. Steel, energy or consumer discretionary have usually low CAP/Turnover, while luxury goods or tech companies have rather high values. The same exercise can be done with the ratio of turnover to the number of employees. A good index of productivity or staff efficiency. Even if this ratio is not a valuation multiple per se, it is relatively useful in the case of companies with high gross margins where it is mainly wages that have an impact on the company's performance.
Finally, it is essential to look at the Enterprise Value (EV) in relation to the EBITDA. The enterprise value corresponds to the market capitalization of the company plus the net debt. The net debt is the total Long Term debt minus the cash. If the company has more cash than it has debt, its net debt will be negative and the EV is then lower than the market capitalization. On the other hand, when the company has more cash than it has debt, then its net debt is positive (which is often the case). It is important to notice that shareholders often want the company to have debts, to improve the return on equity through the leverage effect (difference between economic profitability and financial profitability).
The Enterprise Value then gives a better idea of the total amount of cash a buyer would have to pay in order to buy the company and pay off its debts.
Once you have this EV in your hands (do not panic, you will find the corresponding EV on the MarketScreener company’s profile), you now need the EBITDA, which corresponds to what the company generated over a year, before deducting financial expenses, taxes, depreciation and amortization, and net exceptional income.
The EV/EBITDA multiple, when compared between companies in the same industry, allows us to sort out those that are undervalued compared to the rest of the market and not directly compared to their intrinsic value.
If you pay attention to the different elements outlined in this article, you will be able to understand which companies are likely to be undervalued. However, to avoid investing in dying stocks, you need to look at balance sheet ratios such as the quick ratio, the Long Term debt/equity ratio and check that the company's operating margin is not increasing lower than expenditures. But 'll save that for a future article...