
How to compose a Value Portfolio
Value investing relies on fundamental analysis to determine when
a stock is trading at less than its intrinsic value. This style is the
opposite of growth investing, where investors are willing to chase
after stocks that have good growth records and have already risen
in value. Value investors are bargain hunters who are looking for
companies that have good ideas or products or that have been
performing poorly but have good long-term prospects. A good
example of value stocks are the home-building companies that
have declined in price because of a bubble in the real estate market.
The stocks of these companies are trading at around four times
their earnings multiples. If interest rates in the economy rise, fewer
new homes will be built and sold. Consequently, home-building
companies are attractive investments for value investors who are
willing to wait until the home-building cycle moves back into an
expansionary mode. When a sector of stocks has lagged other stock
sectors over long periods, the gap eventually narrows, and the
laggard sectors likely will outperform those other stock sectors in
the future. This is known as the regression to the mean. The flip side
of the coin is that stocks that have been outperforming the market
likely will revert to the mean and underperform the market at
some stage in the future. Thus value investors are always looking
for stocks that are considered to be trading below their expected
long-term growth rates.
A definition of a value stock is one in which the company’s
P/E ratio is lower than its earnings growth rate. Chesapeake
Energy, for example, is considered a value stock in that its 2007
expected earnings growth rate is 13 percent and its 2007 P/E ratio
is 9.6. A stock whose P/E ratio exceeds its growth rate is not
considered a value stock.
There is not unanimous agreement on the definition of value
stocks. Some definitions center on low P/E multiples or those that are
below the market multiples. Others focus on low multiples of cash
flow or low price-to-book ratios. The most conservative definition of
a value stock is one that has an above-average dividend yield. Outof-
favor stocks are also classified by some as value stocks. For example,
when Intel, Cisco, and many other growth stocks fell in value
in 2006, many value fund managers bought these stocks as value
stocks. Depending, then, on how you define value, many investors
come up with different sets of value stocks. Some of the bases for
determining value stocks are discussed in greater detail below.
Price / Earnings Ratio
The P/E ratio for a stock is calculated by dividing the current market
price of the stock by the earnings per share. This can be done
using the past four quarters’ earnings, which is known as a trailing
P/E ratio. Alternatively, the P/E calculation can use expected earnings
based on forecasts for the upcoming year’s earnings. This
future P/E ratio may be of greater significance to investors because
this is an indication of the expectations for the stock in the future.
However, investors should not base their decisions solely on
P/E multiples because the type of industry and the capital structure
also affect the P/E ratio. Some industries have higher average P/E
ratios than others, and it would not necessarily be a meaningful evaluation
to compare the P/E ratios across industries. For example, the
pharmaceutical companies have much higher multiples than the
brokerage stocks. Comparing Schering-Plough Corporation, then,
with a trailing P/E ratio of 33, with Goldman Sachs, with a P/E ratio
of 11, would be meaningless. Some industries require much greater
investments in property, plant, and equipment than others, which
means that they are probably much more leveraged in terms of debt.
Generally, companies with high debt ratios are much riskier than
companies with low debt ratios, and these more highly leveraged
companies will have lower P/E ratios.
A low P/E ratio is a relative measure. Some investors might
consider Schering-Plough to be a growth stock with a multiple
of 33, whereas others would consider this to be a value stock as
compared with the high multiples of some of the other stocks on
the exchanges.
Price-to-Book Ratio
This measure compares the market price to the book value. The
book value per share is computed as assets minus liabilities divided
by the number of outstanding shares. Value investors look for stocks
with market values that are below their book values. Benjamin
Graham, who did the pioneering work on fundamental analysis,
has some guidelines for stock pickers, which include buying a company’s
stock when the stock price is less than two-thirds the book
value per share.
There are a number of reasons why a low price-to-book ratio
is not reason enough, by itself, to buy a stock. The book value per
share is an accounting measure, and it can be distorted by using different
accounting methods within the generally accepted accounting
principles (GAAP), such as the use of accelerated depreciation versus
straight-line depreciation or last in, first out (LIFO) versus first
in, first out (FIFO) for valuing inventory. The discrepancy between
the historical cost of the company’s assets and their market value
will make the book value per share diverge from the realizable
value per share. Thus it is a good idea to use more than one measure of value
to select value stocks.
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