"Price is what you pay. Value is what you get."
--Warren Buffett
Putting his finger on this difference between price and value
instock investing is essentially what made Warren Buffett the
third-richest person on Earth,
according to Forbes
. Today he's worth more than $44 billion.
What Buffett means is simply this: Every stock on themarket
trades for a certain price, but it's more important to know how
much you're actually getting in return for paying that price.
That's value.
To better explain, let's scalestocks down to lemonade stands.
Say you want to make somemoney and you're deciding between buying
one of two different lemonade stands to do it. Both stands are
being sold by their owners for the same price -- $100.
If you're thinking, "What's the difference between the two
stands?" then you're already thinking like a smart investor. Let's
say one stand earned $20profit last year, while the second stand
earned $100 profit last year. Which stand gives you more value
(i.e. more in return) for your $100investment ?
Let's look at your two investment choices: If you invested $100
into the first stand, then you could earn $20 each year and make
back your original investment in five years. But if you instead
invested $100 into the second stand, then you could make back your
money in one year and start earning profit after that. That's a 20%
annual return versus a 100% annual return on investment. It's clear
that the second lemonade stand is a much better value.
Buffett uses a similar analysis to pick winning stocks. He
practices a strategy called value investing -- essentially buying
companies that have a low stock price in relation to their true
value. In other words, he buysshares of a good company when it's
"on sale." Over time, theundervalued stock's pricewill rise closer
to what it's really worth, and Buffett will enjoy the gains as long
as he holds on to his shares.
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Buffett's track record shows value investing can pay handsomely
if done correctly: theinvestments he chose through his firm,
Berkshire Hathaway (NYSE: BRK-B)
, gained an amazing 513,055% from 1964 to the end of 2011. By
comparison, the S&P 500 (with dividends included) gained just
6,397% during the same stretch.
Lucky for us, almost anyone can follow this successful investing
strategy. First, find a great company that has a strong brand, good
management and healthyearnings .
Then, find out if that company's stock is "on sale." These four
valuation ratios used by expert investors can help you find out if
the stock is a bargain based on its price and value:
1. ForwardPrice-to-Earnings Ratio (ForwardP/E )
Let's again say you want to buy a lemonade stand. Before you make
anoffer , would you rather know how much profit the stand made
during the past year or how much profit the stand is expected to
make in the next 12 months?
The forward P/E ratio essentially tells an investor the latter
information about a stock. (The similar P/E ratio compares price to
the past year's profit -- the firstoption -- to find value.) You
can use the forward P/E ratio to find a stock's value based on
today's stock price and what the company is expected to earn during
the next 12 months. [See examples of forward P/E and learn how
to calculate it here.]
Save Yourself Time:
Morningstar lists a company's forward P/E on itsstock quote pages.
As an example, you can see
Microsoft's (Nasdaq: MSFT)
forward P/E here under the heading "forward valuation." (Note: Keep
in mind that earnings forecasts are based on analyst expectations,
so one analyst's forward P/E may differ slightly from another.)
Is The Stock A Bargain?
Generally, a stock is trading at a good value when its forward P/E
is lower than its P/E ratio, lower than its competitors' forward
P/E ratios and lower than the S&P 500's forward P/E ratio
(which has historically been between 14 and 17). A stock that meets
these criteria means that the company's profits are growing faster
than its peers and the broad market -- and/or trading for a cheaper
share price.
2.Price/Earnings-to-Growth Ratio (
PEG
)
Let's say that someone is willing to sell you their lemonade stand
for the same price it was offered at last year. On its own that may
not sound like a great deal. But what if a reliable source told you
with absolute certainty that the stand will make twice as much
profit in the coming year as it did last year? Not only is the
lemonade stand suddenly twice as valuable, but theoffer price
sounds much more tempting. Paying last year's price for the stand
to earn double the profit couldmean there's potential for earning
double the return on your initial investment.
That's the idea of value investing -- find companies with
inexpensive share prices and strong future earnings growth. You can
find bargain stocks this way by using thePEG ratio, which compares
a company'sprice-to-earnings ratio (P/E) to its expected annual
earnings growth rate (
G
). [See examples of how investors use PEG to find undervalued
stocks here.]
Save Yourself Time:
Morningstar lists a company's PEG based on its own analysts' growth
estimates. For example, you can see Exxon-Mobile's PEG here, under
the heading "forward valuation."
Is The Stock A Bargain?
A stock is often considered a good value when its P/E is lower than
its expected annual earnings growth rate. In other words, if a
stock has a P/E ratio of 30, then the company should be expected to
grow its earnings by 30% or more this year. Otherwise, its stock
price is growing faster than its earnings, and that could mean the
stock isovervalued and headed for acorrection . Look for a PEG
ratio of 1.0 or less (the lower it is, the better the stock's
value).
3. Price-to-Free Cash Flow (P/FCF )
You may have noticed in my previous examples that the P/E, forward
P/E and PEG ratios all use earnings (also known as profit) in their
analysis to find a stock's -- or lemonade stand's -- value. While
earnings are generally a good way to measure a company's overall
health, they can sometimes be manipulated with cleveraccounting
techniques that artificially pump up a company's value. Former
Enron investors know the dangers of that all too well. No one wants
the Enron of lemonade stands.
Fortunately, there's a ratio that can help you find a stock's
value without using earnings. Theprice-to-free cash flow ratio
(P/FCF) compares a company's stock price to itsfree cash flow ,
which is essentially the amount of rawcash the company has left
over after it pays the bills and buys the capital (buildings,
property and equipment) it needs to operate. A company can use its
free cash flow to expand, pay dividends or pay down debt. The more
free cash flow a company has, the more it can potentially grow in
value.
Save Yourself Time:
Morningstar lists a company'sfree cash flow per share under the
"key ratios" tab. Here's here]
Is The Stock A Bargain?
A stock may be a good value if its P/FCF is lower than its prior
years' P/FCF ratios or lower than its competitors' P/FCF ratios. As
a rule of thumb, look for stocks with a P/FCF of less than 10,
which means that the company's free cash flow makes up at least 10%
of its valuation. The lower a company's P/FCF, the more potential
growth you're getting per dollar you invest.
4. Enterprise Value-to-Cash Flows From Operations (EV/CFO)
The P/E ratio is an investor favorite, but it has one glaring flaw:
You can compare a stock's P/E only against peers that are within
its industry -- or you have to compare it against the entire
S&P 500. The EV/CFO ratio, on the other hand, allows investors
to compare the value of one company to any other company,
regardless of industry, on an apples-to-applesbasis .
Let's break down the EV/CFO ratio.
EV:
Just as smart car shoppers don't like to pay the sticker price for
cars, value investors don't always like to pay the market's stock
price for companies.Enterprise value (EV ) tells an investor how
much it would cost to buy a company after taking into account how
much debt and cash it carries. A larger company looking to acquire
a smaller firm typically finds that company's EV before they make
abuyout offer -- ensuring a fair deal.
CFO:
Cash flow from operations (CFO) tells an investor how much raw cash
a company's core business generates. The higher the CFO, the
healthier the business. CFO makes it easier to do an
apples-to-apples comparison between companies because it strips out
depreciating assets andtax rate implications that vary from
business to business.
Combined, EV and CFO make up the versatile EV/CFO ratio that can
be used to compare valuations of several different types of
companies.
Save Yourself Time:
Yahoo (Nasdaq: YHOO)
Finance calculates a very similar valuation ratio for you -- the
EV/EBITDA ratio. Here's here.]
Is The Stock A Bargain?
A stock with a EV/CFO ratio that is 10 or less represents a
very good value. That essentially means that it would take less
than 10 years for the company to pay for itself (i.e. buy all of
its outstanding stock and pay off all its debts) if it were to use
the operating cash it generates each year.
Action to Take -->
Remember, no single valuation ratio is the magicbullet that
can tell you if a stock is a bargain, so usemultiple valuation
ratios for best results.
Think of each of these ratios as a different "test" that
measures if a stock is overpriced, fairly priced or undervalued.
The more of these tests you run on a stock, the better you'll be
able to tell if it's truly a diamond in the rough that's ready to
be snapped up -- and the higher your chance of investing
success.
This article originally appeared on InvestingAnswers.com:
Find Bargain Stocks Like Buffett With These 4 Value Ratios