Many years ago Benjamin Graham developed a formula for evaluating stocks on both an earnings and asset basis. He thought that, on average, you should not pay more than 15 times earnings or 1.5 times book value for stocks.
So he came up with a simple formula. You multiply the PE ratio by the price-to-book-value ratio and if the result of this simple equation is less than 22.5, the stock is trading for less than fair value. Graham acknowledged that the earnings would sometimes be so good you might want to pay a little more, or that the asset value discount was high enough you may be willing to pay a little more of an earnings multiple as well.
It is relatively easy to put together a list of stocks trading below fair value using a stock screener and a simple spreadsheet. I am a big fan of combining theories to find new ways to look at stocks, so I ranked the stocks on the list according to their Piotroksi F-scores. The F-score was developed back in 2000 and is a very quick effective way to check on a company’s finances and prospects. The score measure nine factors in the financial statements and the higher the score the better the prospects of the company and the stock price.
Gas Natural (EGAS) makes the grade as a potentially undervalued company with strong prospects. The company distributes natural gas to 69,000 customers through regulated utilities in Kentucky, Maine, Montana, North Carolina, Ohio, Pennsylvania, and Wyoming. EGAS also owns 160 natural gas wells and gas gathering assets in Montana along with two pipelines in the state. The PE ratio is 14 and the shares fetch 1.3 times book right now, with a result of 18.2 so we are way below the 22.5 cutoff for fair valuation.
PHI Incorporated (PHII) provides air transportation services to the oil and gas companies as well as medical transportation services for hospitals and emergency services agencies. The company also provides offers helicopter repair and overhaul services for existing flight operations customers. PHI’s helicopter fleet currently has 268 aircraft, including 165 aircraft for Oil and Gas segment, 97 aircraft for Air Medical segment, and 6 used by the National Science Foundation in Antarctica. The stocks trades at 12 times earnings and 1.1 times book value, so the shares are trading at about 60% of the Graham fair value level.
When I review the list I also find it interesting that many stocks considered to be undervalued have horrible fundamentals and very low F-scores. Stocks like JC Penny (JCP), Ruby Tuesday (RT) and Lincoln Education Services (LINC) may trade for less than fair value, but their prospects appear very limited and they have F-scores in the lower third of the market universe.
Combining the ageless theories of ben Graham and newer ones developed by professors such as Joseph Piotroski can help us find undervalued stocks with outstanding potential and avoid those that may not perform very well due to poor business and financial conditions.
As of this writing, Tim Melvin did not hold a position in any of the aforementioned securities.