The Difference Between Cheap Stocks and Undervalued Stocks

Here are some simple ways to hone your value investing

   

If you’re like me, you like a good bargain anytime you can get it. That’s why I’m an eBay fanatic! But I especially like bargains when it comes to investing because you not only get a good discount, you can watch it appreciate in value and then cash out with nice profits.

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Value investing is the bargain bin of Wall Street. I know. I know. Value investing is boring, right?

Fact: From January 1994 to January 2013, the Russell 3000 Value Index (a broad measure of value stocks) returned 10.36% compared to the 8.71% rise in the Russell 3000 Growth Index. If that’s boring, I’ll take it.

However, cheap doesn’t automatically equal value. Just like searching through the bargain bin or clearance rack at a store, you have to know how to separate the cheap stocks from the undervalued stocks. A lot of stocks are cheap because they deserve to be, but others are undervalued stocks compared to what they’re ultimately worth. Knowing how to distinguish between cheap stocks and undervalued stocks is obviously critical, and that’s what we do in my Value Authority investing service.

Here are some of the screens we use as part of our process to finding undervalued stocks:

Valuation Screens

  • Price-to-Earnings Ratio: A good starting point is to look for stocks with a P/E ratio below the overall market or less than the average of the sector within which a company operates.
  • Price-to-Cash flow: As a general rule, I like this to be below 18 (so you’re getting a 5.5% return). Free cash flow is basically cash from operations less capital expenditures. I like that companies can’t use different accounting methods to come up with a different number the way they can with earnings. Cash flow is cash flow. Period.
  • Enterprise Value-to-EBITDA (earnings before interest, taxes, depreciation and amortization): This ratio is highly industry dependent, but I prefer it to be no more than 10. Enterprise value is a more comprehensive measure of value than market capitalization. You start with the market cap, add in other factors (debt, minority interest and preferred shares), then subtract cash and cash equivalents. EBITDA is used a lot when are acquired, which happens frequently with value stocks because of their attractive discount.

Balance Sheet

  • Debt-to-Capital: Nothing can destroy shareholders’ values as much as excessive debt, especially when the company or the economy hits a rough patch. Interest payments on debt can’t easily be reduced or eliminated. To avoid potential problems, I like companies with debt of no more than 50% of their total capital (which includes debt plus the total owned by shareholders).

Return on Invested Assets

  • Return on Equity: A good way to measure this is Return on Equity (ROE). I look for at least 12%, but I also examine it over time. You may find a company with ROE over 12%, but if that number has been declining — even while earnings are growing — it could be headed for trouble, as its investments in assets are producing less of a return.

Growth

  • Revenue and Earnings Growth: We can find a lot of “cheap” stocks, but the most important way they increase in value is through growth. Without it, they are likely to stay cheap. We don’t need off-the-charts growth, so I start by screening for companies that have grown revenues at least 2% per year over the past five years. I also look for at least 5% to 7% growth in earnings.

One Step Further

These screens are important, but keep in mind that they are the starting point. Some companies, such as those undergoing significant turnarounds, may not meet all the requirements for the screens but can still be solid investments. And after running these screens and coming up with possible value plays, I do a deeper dive into the specifics of each company to find the most compelling opportunities.

In all cases, of course, we’re looking for stocks that are undervalued with identifiable catalysts to move the stock higher. These give us nice upside potential with what Benjamin Graham called a “margin of safety,” meaning less downside risk. That’s a powerful combination for building wealth.


Article printed from InvestorPlace Media, http://investorplace.com/2014/09/value-investing-undervalued-stocks-cheap-stocks/.

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