Value Investing: a timeless stock-picking strategy

To get some true picture of a company’s value, investor should analyse it based on various aspects, but here we want to sum up six of the most known criterion in the investment’s world.

The six yardsticks are:

1. Price-to-earnings;
2. Price-to-sales;
3. Price-to-book;
4. Earnings Yield;
5. PEG ratio.

1. The price-to-earnings (P/S) is calculated dividing stock’s share price by its earnings per share. The higher the P/E ratio is, the greater the investors’ expectation are about the company’s growth. In fact, a high P/E value indicates that the market is willing to pay a lot, given the level of profits, since it believes  the company will be able to increase them further. Frequently, given the same financial performance, a lower P/E ratio express a cheap price and may indicate possible undervaluation.

2. The price-to-sales (P/S) ratio divides the stock’s share price by its sales revenue per share. This indicator varies depending on the industry and does not take into account neither the financial nor the debt structure of a company. It’s useful to use this indicator when comparing similar companies. A lower P/S ratio may indicate a possible undervaluation. “The P/S reflects how many times investors are paying for every dollar of a company’s sales.” (investopedia)

3. The price-to-book ratio (P/B ratio) is the ratio between the stock’s share price and the the company’s capital value per share resulting from the balance sheet (book value) . The securities sold at a price well below the book value of shareholders’ equity are generally considered good candidates for undervalued portfolio; on the other hand, those sold at a higher price than the book value, are the target of overvalued portfolios.

4. Earnings yield are the earnings per share divided by the current market price per share. It is the reciprocal of  the P/E ratio. This quotient express how expensive a company is in relation to the earnings the company generate and allows investors to identify those stocks trading at a bargain price. It possible to adjust the earnings yield formula to take in account that different companies have different financial and debt structure. 

Adjusted formula [via wikipedia]:

Earnings Yield = (Earnings Before Interest & Taxes + Depreciation – CapEx) / Enterprise Value (Market Value + Debt – Cash)  

5. The price/earnings to growth (PEG ratio),  is the relationship between the price-to-earnings (P/E) and the annual revenue’s growth rate a company. If the P/E ratio of a company is higher than the growth rate, and so the PEG is greater than one, this means that the stock’s share price is relatively expensive; vice versa, if P/E is lower than the growth rate, and then the PEG is less than one, this is seen by  analysts as a sign of favourable purchase. Looking for stocks based on their PEG ratios can be a good way to find companies that are undervalued but growing, and could gain attention in the upcoming quarters.

Backtesting the strategy

Nowadays, there are many software tools out there that provide the ability to backtest our investment strategy before putting our own capital at risk. Using a screening tool, investors are able to filter and research stocks based on the key metrics chosen for their due diligence.

In our case we used a screen, according to the value investing principles,which follows these rules to set our portfolio up:

1. price-to-sales ratio less than 0.80: sales revenues should be at least 25% more than the current price value;
2. net-margin last five years grater than 5%: looking at a five-year average provides a good sense of how the business usually performs;
3. total-debt-to-equity less than 40%: debt is a source of capital but it can be a burden when times turn tough. We look for a well balanced financial structure here;
4. return-on-investment last five years greater than 12% : specify how profitable the company is and provide a good picture of the true company’s essence;
5. free-cash-flow grater than 0: represent the ability of the company to generate cash after spending for all capital expenditure.
6. earnings-per-share growth last 10 years greater than 5%: companies that had an higher earnings growth rate in the last 10 years on average.

The results of this screening are surprising. Let’s start an equally weighted portfolio on march 3, 2012 with a value of $100,000 and ended on March 03, 2017 with a market value of 246,784.33 for a holding period return of 146.58%. During the same period, the S&P 500 had a return of 73.91% as we can see from the exhibit above. One of the most relevant aspects in our analysis is related to the risk factor. Firstly, the portfolio Sharpe ratio of 1.08 shows that for every 1 unit of risk our portfolio is able to generate 1.08% in excess return compared to an equivalent risk free investment. Also, the Sortino ratio of 1.64 expresses that the variability of returns does not focus predominantly below the minimum acceptable. We can conclude that our investments have a well justified return related to the associate risks.