When investors look for cheap stocks, they often concentrate on the ratios of price to earnings, price to cash flow, price to book value and price to sales. Those investors often find stocks significantly outperforming the S&P
This article published with permission from InvestmentU.com.
My mother believes shopping is a sport. If it were, there’s no doubt she would be a world champion. I’d say an Olympic gold medalist, but she lost her amateur status years ago.
When my mom shops, she’s not satisfied unless she’s getting top merchandise for at least 40% off.
And like a hunter who can’t wait to brag about the 12-point buck he took, my mother will tell anyone who’ll listen about the $300 sweater she got for $80. But unlike the tales of hunters and fishermen, when it comes to my mom and shopping, the big one doesn’t get away.
Everyone loves a bargain. But some people are willing to work harder to get it. Investors are like shoppers. Some will stand in line to buy the latest hot Apple product (or stock), while others will wait patiently until the product or stock they want goes on sale.
When investors look for cheap stocks, they often concentrate on the price-to-earnings ratio (P/E). The P/E is simply the price per share divided by the past year’s earnings per share.
So in the case of Intel (Nasdaq: INTC), for example, the company earned $2.36 per share in the last 12 months. The current share price is $27.69. Divide $27.69 by $2.36 and you get a P/E of 11.7.
You can use that number to compare it to the P/E of the S&P 500 (15.3), its industry average (15.4), its historical average (17.1) or other specific stocks in its sector, to get an idea of whether the stock is cheap or pricey.
Analysts also look at forward price to earnings, which divides the price by the consensus analyst estimate for the next year. In Intel’s case, analysts project earnings of $2.49 per share in 2012, giving it a forward P/E of 11.1.
Methods better than P/E
But I believe investors pay too much attention to earnings and not enough to cash flow. You can also obtain a company’s valuation based on price to cash flow and, like P/E, compare it to industry averages, the S&P 500, etc.
Other popular valuation metrics include the price-to-sales ratio (P/S), which is the share price divided by revenue per share. If revenue per share isn’t readily available, all you do is divide the last 12 months’ sales and divide by the number of shares.
Price to book value (P/B) is also a popular tool. Book value is the value of the assets investors would get if the company were liquidated. Book value is simply shareholders’ equity (found on the balance sheet) divided by the number of shares outstanding.
Which one is more important when it comes to price performance?
Let’s take a look at each. I ran a stock screen and a corresponding backtest to measure the performance of all stocks whose valuation in each of those four metrics (separately) was below the average of its industry.
Over the past 10 years, if you bought every company (that was profitable) trading below its industry’s average P/E and held the stock for one year, you’d have outperformed the S&P 500 by 218%. In only two out of the 10 years would that formula have underperformed the market — and not by much.
A recent example is Apache Corporation (NYSE: APA), trading at 7.8 times earnings versus the average insurer at 17.8.
Price to cash flow
Testing undervalued, cheap stocks based on price-to-cash flow also turned out a stellar outcome, beating the market by 749%. It underperformed the market in three out of 10 years, but the worst year was only by 3.15%. Conversely, in six of the seven years it beat the market it did so by double digits, several times by 50% or higher.
Sprint Nextel (NYSE: S) currently trades at just 1.9 times cash flow, which is dirt cheap, even in its industry, which only trades at an average of 4.6 times cash flow, compared to the S&P 500, which is valued at 9.1 times cash flow.
Price to book value
The results were even better on stocks trading at a lower price-to-book value than their industry average. Over the 10-year period, those stocks climbed 2,193% versus the 13% of the S&P 500. These stocks beat the market every year, including by over 100% in 2009 and 2010.
A current example is NVIDIA Corporation (Nasdaq: NVDA), which trades at 1.8 times its book value, versus its industry average of 2.8.
When I ran the backtest using companies whose price-to-sales ratio was below the industry average, something incredible happened. A $1,000 investment in 2001 turned into $286,535! While the same amount invested in the S&P 500 was worth $1,130.
The screen beat the S&P 500 in every year. But what was really interesting was that in 2003 and 2009, years in which the overall market recovered from steep sell-offs, the low P/S stocks went nuts. They outperformed the S&P 500 by 232% in 2003 and 745% in 2009.
Keep in mind, this involved owning a few thousand stocks, so this isn’t easily copied in real life, but it might give you a starting point the next time we start to come out of a nasty bear market.
Symantec (Nasdaq: SYMC) is a current example, trading at just 1.8 times sales versus its peers’ average of 3.8 times sales.
You obviously don’t want to run a screen, throw a dart at the list and buy a stock. You want to dig a little deeper. But by knowing which types of stocks tend to outperform the market, you increase your chances of getting a bargain that you’ll be as happy with as my mother is with a $400 designer jacket that she got for $35 (true story).