Some of the wealthiest investors in the world are value investors who look to buy stocks at bargain prices and make money over long time periods. They search for stocks “on sale” so the risk of losing is limited, and generally a lot lower than the downside risk when buying a high flying stock.
Often, the best value stocks are out of favor and overlooked by the general investing public, who pay more attention to popular stocks in the news. If you want to follow in the footsteps of the richest value investors in the world and limit your downside risk, you will need to focus like them on what matters most: intrinsic value.
To find top value stocks, successful investors calculate the intrinsic values or fair values of companies and compare these values to current market capitalizations. When a company’s intrinsic value is higher than its current market price, value investors view the stock as undervalued.
Value investors also examine price/earnings ratios, free cash flow yield, book value, high dividend yields and other metrics. To save you the legwork of calculating these financial ratios, we share a list of stocks below that have been screened using a handful of financial metrics used by value investors.
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Find Value Stocks Not Cheap Stocks
Undervalued stocks are not always stocks that have declined in share price. Sometimes a cheap stock can be overvalued because a fundamental reason has caused the share price to decline. When the stock has been sold for fundamental reasons, the share price is unlikely to bounce back anytime soon, so buying the stock would be a speculative gamble, not an investment.
Value investors are looking for bargain-priced stocks that are fundamentally solid. A stock that is trading at a low share price may seem cheap but is not necessarily a value stock. It is important to distinguish between a share price decline due to fundamental reasons relating to the company and reasons independent of the company.
Sometimes a share price that has declined a lot reflects serious fundamental issues in the company. Perhaps a blockbuster drug the company relied on for future growth has been denied approval by the FDA. Maybe a visionary CEO has departed. Or a class action lawsuit has added unforeseen liability to the company’s balance sheet. Even worse, the market size and opportunity may be in jeopardy which would limit future revenue potential for the company.
If the decline in share price is unrelated to the company but instead is attributable to a general stock market sell-off, then maybe the chance to scoop up a value stock at a good price is available. But which financial metrics will give you confidence that you are buying a discounted value stock as opposed to a cheap, low-quality stock?
Dividend Paying Stocks Limit Downside Risk
One way to screen for value stocks is to find dividend paying stocks with long established histories of paying and ideally increasing dividend payments annually.
A sign that a company is fundamentally strong is when it pays a dividend consistently and the dividend yield is at least 70% of the yield of a long-term AAA bond. This is not a hard and fast rule because some fundamentally solid companies, such as Berkshire Hathaway, pay no dividend at all.
When you buy a value stock, you are betting that the share price will rise over time. And one of the best ways to predict whether the share price will increase is when earnings growth is expected.
A good rule of thumb is to look for stocks that have a history of growing earnings by at least 7-8% per year. Ideally, you want to see they have grown earnings at this rate during booms and busts, so over a 10-12 year period.
If a company’s earnings contract during economic recessions but bounce back thereafter, it is not necessarily a black mark against the company. It is quite normal for earnings to decline during recessionary periods, but the key is that earnings bounce back quickly when the good times resume.
The reason positive earnings growth is so important is that share prices are directly impacted by earnings. Companies are valued at multiples of earnings so even if multiples remain constant, share prices can rise as earnings rise.
For example, if a company has an earnings multiple of 10 and generates $1 of earnings, its share price will be $10. Investors typically apply the same or higher multiples to stocks that are growing earnings fast. So, if earnings increase from $1 per share to $1.50 per share yet the multiple remains at 10, then the share price will increase from $10 to $15.
Quickly you can observe how important it is for earnings to grow. Even a multiple that doesn’t change will result in the share price increasing. And even better, when earnings are growing fast, investors often reward the company with a higher multiple, which causes further share price appreciation.
Here you can see an example of a company, Google, projected to have growing earnings for the foreseeable future:
Spot Undervalued Stocks: Calculate Fair Value
If a company’s intrinsic value is high compared to the price at which it is trading in the market, it is said to be trading at a discount to fair value. But how do you calculate fair value?
Wall Street analysts build financial models for companies to calculate fair value. For example, the financial model below for D.R. Horton shows summary financials for a 5 year period. These include revenue projections and operating income, known as EBIT, or earnings before interest and tax.
When you research any company, you will need to analyze all the financial statements: Income Statement, Balance Sheet, and Cash Flow Statement. For example, on the Income Statement you will need to estimate how fast revenues and costs will rise or fall in coming years.
On the Balance Sheet, you may need to make assumptions for inventory, accounts receivable, and goodwill charges.
To save yourself the hassle, view a list like the one below that incorporates multiple valuation models to find the consensus fair value as well as a valuation range:
- Discounted cash flow forecast
- P/E multiples
- Dividend forecast model
- Revenue multiples
- Earnings power value
How To Pick Stocks To Buy With Strong Upside
The best value stocks to buy have strong upside potential. A rule of thumb is that if fair value is at least 20% higher than the current share price, the upside potential is high.
One quick way to gauge whether the upside potential is high is to look at the consensus price target among Wall Street analysts. Generally, price targets calculated by analysts cluster around similar levels, but if a wide price range is evident, consider screening out prices at the extremes of the range and select the median price target as a benchmark.
It is generally a good idea to filter out companies that have low market capitalizations, under $250 million. For example, penny stocks are publicly traded companies traded on the OTC market with low market capitalizations. These companies trading as penny stocks often have unproven business models and the lack of transparency into business practices means it’s hard to discern the value stocks from the junk stocks.
Select Companies With Low Default
Risk Using The Altman Z Score
Top value stocks have low default risk and one way to measure that risk is the Altman Z score.
The z-score formula for predicting bankruptcy was developed by Edward Altman. The intent of the Altman Z-score is to predict bankruptcy within 2 years.
The Altman Z-score is calculated as:
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
A = Working Capital / Total Assets
B = Retained Earnings / Total Assets
C = EBIT / Total Assets
D = Market Value of Equity / Total Liabilities
E = Sales / Total Assets
A score below 1.8 signifies that the company has a high likelihood of going bankrupt while a score above 3 suggests that bankruptcy is unlikely.
A list of stocks that have low default risk according to Altman’s Z-score include:
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