To succeed as a value investor takes more than just understanding the concepts. It’s necessary to develop skills in financial analysis. Let’s discuss some advanced tools and strategies that can help you become a more sophisticated value investor.
A company’s financial statements—the balance sheet, income statement, and cash flow statement—are a roadmap to understanding the true value of any business. While all this financial information might seem overwhelming at first glance, it’s not as intimidating as it looks. Learning to read and interpret financial statements is non-negotiable for a serious value investor.
The income statement1, also referred to as a profit and loss (P&L) statement, is the financial document that reports revenues, expenses, and the net profit or loss for a specified period, typically at the end of every quarter and at year-end. Here are a few things to look for:
Revenue growth: At the top line (revenue is the first line on the income statement), you’ll want to see stable, consistent, and sustainable growth rather than dramatic jumps. Revenue growth of five to 10 percent annually over a multi-year period is considered more attractive to value investors than a significant increase followed by declines.
Operating margins: This metric tells us how efficiently a company has converted sales into profits over time. Compare margins to industry averages and historical performance. To find industry average financial ratios, you can look to information providers such as IBISWorld, Standard & Poor’s, or Risk Management Association. These are all subscription-based services, so you might be well-served to visit your local public library.
Earnings quality2: Not all earnings are created equal. While no returns are guaranteed and all investing involves risk, the metric of earnings quality considers how reliable an indicator a company’s past earnings are of potential future performance and cash flow. High-quality earnings are generated from operations rather than accounting machinations. Divide cash flow by net income to determine how much of reported net income is backed by actual cash from operations. You’ll want to look for a ratio that is consistently greater than one. If the ratio is less than one, the company is relying on accruals (non-cash items) to boost net income.
The balance sheet tracks assets, liabilities, and equity, with the total of assets and liabilities equal to equity. It’s a snapshot of what the company owns and owes. Key financial ratios to consider include:
Debt-to-equity ratio: Healthy companies don’t take on extremely high levels of debt. The amount of debt considered reasonable varies by industry, with some industries carrying higher levels of debt due to the nature of their operations. For example, service industry businesses tend to carry less debt while businesses in capital-intensive industries will have higher debt levels. You should compare a company’s debt-to-equity ratios (total liabilities/total shareholders’ equity) with industry averages, which are publicly available on the New York University Stern School of Business website.3
Current ratio: Calculated by dividing current assets by current liabilities, this metric addresses a company's ability to meet its short-term obligations. A ratio between 1.5 and 3 is generally considered good, though this can vary somewhat by industry.
Book value: This metric is calculated by subtracting total liabilities from total equities. It would be the company’s total value if it were liquidated immediately. The figure is best used for businesses that have considerable physical assets, such as manufacturing companies.
The cash flow statement shows how much actual cash is moving in and out of a company. Famed value investor Warren Buffet once said, "Cash is king," and value investors should keep this in mind.
Free cash flow: Free cash flow is the amount of cash generated from operations minus capital expenditures. Companies with strong, consistent free cash flow have the capacity to return money to shareholders through stock dividends or buybacks.
Sophisticated value investors use a variety of methods to estimate a company’s intrinsic value. Here are some of the most common techniques:
DCF analysis estimates a company's value by projecting future cash flows (commonly for a period of ten years) and determining today’s value of those cashflows by discounting them back to the present, using a discount rate that reflects the risk and the time value of money. While complex, this method provides a fundamental view of what a company is worth.
Project the future cash flows using the current financial statements. You can develop a set of assumptions to project future cash flows by looking at historical financials.
Start with projecting a growth rate for revenue. You might use the average of the historical growth rate over a five-year period, for example. Or, you might use a figure based on your outlook for the industry. We believe it’s always best to be fairly conservative with your assumptions about growth rates and expenses.
Analysts typically create a set of pro forma financial statements based on assumptions about revenues and expenses. The easiest way to estimate is to take historical averages. For the balance sheet, you might consider line items as a percentage of total assets and then take a historical average to make projections. For the income statement, you can make projections based on line items as a percentage of revenue. Once you’ve created the projected balance sheet and income statement, you can use those to build a pro forma cash flow statement.
The discount rate should accurately reflect the company’s risk. You’ll want to consider the cost of debt, the cost of equity, and potentially add a premium based on your estimate. It’s important to remember that discounted cash flow analysis is more of an art than a science, and is based on assumptions informed by historical performance.
To use this method, you should identify a group of comparable companies that operate in the same industry, have similar business models, and are of similar size to your target company. Then you can use the following metrics to value your company:
For example, if similar companies trade at 15 times earnings and your target trades at 10 times earnings with comparable fundamentals, the target may be undervalued. Oftentimes, this method is used in conjunction with discounted cash flow analysis.
Some companies trade below the value of their assets, creating potential opportunities. This valuation method might be suitable for companies with significant tangible assets, such as real estate, inventory, or equipment.
Calculate the replacement cost of assets and subtract the company’s liabilities. If the market capitalization is significantly below this figure, you might ask why the market is putting such a low value on the company.
No investor, even the most experienced, is infallible. Here are some common pitfalls with the potential to derail your success:
Just because a stock is cheap doesn’t mean that it’s a good investment. Some stocks are cheap for a reason. Maybe the company is trading at a low valuation because their business model is dying, or its markets are disappearing. For example, think about traditional brick-and-mortar retailers in the face of competition from online retail.
Before you invest, ask yourself whether the company is cheap because it’s not getting the appropriate attention from investors, or because its business is fundamentally impaired.
The stock price certainly matters, but quality matters more. A mediocre company at a great price is often a worse investment than a great company at a fair price. Look for businesses with:
Just because a stock has fallen 50 percent doesn't mean it can't fall another 50 percent. You must always understand why a stock is declining before assuming it's a bargain. Sometimes the market knows something you don't.
Diversification remains important even for value investors. Don't put all your eggs in one basket, regardless of how confident you feel about a particular investment.
Successful value investing requires investors to take a systematic approach:
Screen for candidates: Use financial databases to identify companies that meet your criteria (low P/E ratios, strong balance sheets, etc.)
Conduct intensive research: Read annual reports, conference call transcripts, and industry analyst reports. You’ll be surprised what you can find in an online search. Also be sure to look at the investor relations portion of company websites for useful information.
Calculate intrinsic value: Use multiple valuation methods to estimate what the company is worth.
Don’t expect to make an overnight fortune as a value investor. This is a disciplined investment strategy that’s intended to help you build wealth over time. Take the time to develop your skills in financial analysis. As you build your skill set, you can build a "virtual" portfolio to test your ideas before you commit real money.
The most skilled investors read widely, study successful investors, and learn from both successes and failures. Remember, even Warren Buffett has made mistakes; the key is to learn from these mistakes and maintain discipline in your approach. With persistence and diligence, you can master the analytical and valuation techniques you need to succeed as a value investor and look for the hidden gems that others have missed.