By Phil Oakley
Value investing – buying stocks when they're under priced by the market –
is one of the few investment strategies that consistently works over the long
run. But it's not a painting-by-numbers exercise. You can't just input data
into a stock-screening tool and blindly buy the results. The risk is that you
end up buying stocks that are cheap for a good reason. Here are some of the
pitfalls of three classic value strategies – and how to avoid them.
Low price/earnings (p/e) ratios
The price/earnings (p/e) ratio of a stock is very simple to compute – just
divide the share price by earnings per share (EPS). The lower it is, the
cheaper the stock. But just buying a stock with a low p/e is no guarantee of
success. A low p/e could be the result of various problems, such as:
Low growth prospects: the price of a stock is a function of its future
profitability. Companies in declining industries with falling profits should
trade on low p/es.
Fiddled figures: the denominator of the p/e ratio – EPS – is based on
accounting earnings. Although a company has to meet with accounting standards
when stating its profits, there is much scope for manipulation. Companies with
aggressive accounting policies are probably best avoided and should trade on
low p/es.
Peaking earnings: a cyclical company – such as a house builder – may have a
low p/e because its profits have peaked and are set to fall as the business
cycle turns. Although it is time-consuming, it is better for investors to
compute p/es for cyclical companies using an average of five or ten years'
earnings and compare this ratio over time.
Low tax charges: be wary of companies with low p/es and low tax charges.
If the low tax charge is temporary and begins to rise, profits can fall and the
p/e rise. Where possible, compute the p/e on the basis of fully taxed EPS.
Debt: consider two companies, A and B. Each has £100m of assets, trading
profit of £10m and identical growth prospects. A has no debt (£100m equity),
but B finances its assets with £50m of debt and £50m of equity. Assuming tax
rates of 25%, interest costs of 6% and both market caps equally stated equity.
A has a p/e of 13.3 (£100m/£7.5m) and B's is 9.5 (£50m/£5.25m). But can B
really be cheaper than A? This is where the enterprise p/e ratio comes in
handy. Unlike a normal p/e, this factors in company debt levels. By taking the
enterprise values (debt + equity) of A and B and dividing by the after-tax (but
pre-debt) operating profits, we can see that the p/es are the same at 13.3
(£100m/£7.5m), which makes sense.
High dividend yields:
Dividends represent tangible returns that are independent of the stockmarket.
Buying shares with a high dividend yield can be a good investment strategy
(especially if dividends are reinvested), but you should also look at the
following:
High payout ratio/low dividend cover: a high yield may result from a
company paying out most of its profits in dividends, resulting in a low level
of dividend cover (net profits divided by dividend payments). This suggests the
dividend could be unsustainable if business conditions deteriorate. Also, if a
firm is paying out most of its profits, it means they're not being reinvested
to grow the business. As a rule, you want shares with dividend cover of two
times or more.
Look for growth potential: without dividend growth, the returns from a
high-dividend yield strategy are unlikely to be stellar.
Buy stocks with a high free cash-flow yield: From an accounting perspective,
dividends are paid from profits, but in reality they require sufficient surplus
cash flow. Free cash flow represents the cash left over for dividends after
non-discretionary spending, such as interest, tax and capital expenditure.
Buying stocks with a high free cash-flow yield as well as a high dividend yield
may prove to be a conservative and fruitful strategy. Free cash dividend cover
of 1.5 to 2 times is desirable (see Tim Bennett's video tutorial for more on
EPS and free cash-flow yield.
Low price-to-book (p/b) value
This strategy involves buying a company for less than its accounting book value
(or shareholders' equity) and was used to great success by value investors such
as Benjamin Graham. Key points to remember here are:
Book value is an accounting measure: it may or may not be a relevant
indicator of commercial value. To be a successful practitioner of low price to
book (p/b) value investing you need to be able to assess the liquidation value
of assets on the balance sheet, ie. how much money would be raised if all the
companies' assets were sold tomorrow. This may be easy if most of the assets are
cash, but stocks, debtors and fixed assets can be harder to value. Many company
book values have large proportions of intangible assets that are difficult to
value.
Poor businesses aren't worth book value: asset values are a function of
the cash flows they produce. Investors can check the reality of balance sheet
asset values by calculating a company's return on capital employed (ROCE). As a
rough rule of thumb, a company with a ROCE consistently below 10% may have
assets that are impaired and need writing down to more realistic values.
Focus on earnings power values (EPVs) instead: this is where you calculate
the sustainable profits of a business and value it as a perpetual cash flow.
For example, if a business has sustainable profits of £100m and you require a
return of 10%, it is worth £1bn (£100m/10%). If you can buy the business at a
significant discount to this value, you may have a good value investment.
Source:http://www.moneyweek.com/investment-advice/how-to-invest/strategies/the-pitfalls-of-value-investing-53516
