"Risk comes from not knowing what you’re doing."
– Warren Buffet
Price to earnings ratio:
The first step to selecting a value stock is understanding the Price to Earnings (P/E) Ratio. This is a simple equation for calculating value, by working out the relationship between the actual price of a share and its earnings per share (EPS). This information can be found in annual reports or from a stock broker.
The P/E formula is
Price of share
Earnings per Share
For example, if a share is selling at $15 and is currently earning 50 cents per share, the P/E ratio looks like this
Price = 15 = 30
There is some subjectivity in this area, but most brokers would agree that a P/E of
0 to 6 = worryingly cheap
6 to 12 = good value
The market average is 15 and anything over 18 is becoming expensive.
Jeremy Hook, investment director at TMS Capital says there’s more to the equation than simple maths. “The reality is that it may be better to buy a stock on a P/E of 19 or 20 than the one on the P/E of 9 or 10, because its earnings, potentially, might grow faster.”
Julia Lee adds, “If stocks are trading at a significant discount, usually there’s a reason why. Look into why. If it’s just been unloved or overlooked for some reason, that’s good.”
Beyond the P/E is the company’s intrinsic value. Even if a company has an attractive P/E, it must also have some value in terms of its strengths and opportunities in business. Thorough research is the only real way to uncover intrinsic value, including looking at annual reports, the internet, and mentions of the company in the press.
All publicly listed companies must be transparent so it’s easy to find cash-flow charts, profit and loss statements, balance sheets and lists of assets.
Look for companies
• with an attractive P/E
• that are also profitable
• have manageable or no debt, and
• are strongly placed in their market in terms of competition and brand recognition.
Get to know the business inside and out. Andrew Doherty, head of equities at Morningside Australasia says, “Don’t invest in a company you don’t understand, because you can’t predict where it’s heading.”
Chris Kimber, managing director at Fat Prophets says, “You’re actually buying a business, a real company. You’re not buying a share price, you’re not buying a chart. You’re buying a business that has people employed, that has income and profit. It’s a real thing.”
Intrinsic value can also be found in looking beyond the figures. What are the managers like?. Have they run the business well? Have they got their own money invested in the business?Look at the list of top shareholders in a company’s annual report and check how many shares are owned by the executives.