How to Pick a Value Stock
While a stock's fundamental value is determined by the company's actual financial performance, its market value as seen by different investors can be subjective. There is often a discrepancy between a stock's intrinsic value and trading price. When investors take into consideration of positive outlook on a company's future performance, its stock price tends to trade at a higher price level compared to current fundamental value. Conversely, when investors underestimate a company's growth potential, its stock is likely to trade at a lower price level. By comparing business value with market price, investors can pick up stocks that are undervalued.
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Instructions
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Calculate stock value. A stock's fundamental value, or intrinsic value, is often expressed as book value in financial reporting. Book value of common equity has three components: common stock par value, the amount of additional paid-in capital and the total accumulated retained earnings. The numbers are all listed in the shareholder-equity section of a company's balance sheet. Add up the data and subtract any treasury stock, the dollar amount of shares that the company has bought back. Treasury stock is normally listed below retained earnings. Next, divide the total sum by the number of shares outstanding to arrive at book value per share.
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Evaluate business fundamentals. How investors see a business's future performance determines how much they are willing to pay for the stock. Performance measures may include profit margin, rate of return and year-over-year growth in sales or earnings. To compute profit margin and rate of return, divide profit or income by total sales and equity capital, respectively. Sales or earnings growth is often expressed as a year-over-year percentage change. After gathering current performance data, compare them with both the company's past performance and the industry average to arrive at an evaluation on the future prospects of the business fundamentals.
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Compare calculated stock value with the stock's current trading price. In stock valuation, this comparison is referred to as price-to-book ratio. A stock may be traded a few times over its book value or even at a discount to the book value. Whether a high or low ratio is justified depends on investors' evaluation on business fundamentals. If price-to-book ratio for a stock is high and there is a negative evaluation about the stock's business fundamentals by certain investors, to them the stock may be overvalued by the market. If price-to-book ratio is low and some investors have a positive view on the stock's business fundamentals, those investors may pick the stock as a value stock.
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Tips & Warnings
To compare how a stock is priced relative to business fundamentals, price-to-earnings ratio, also known as P/E ratio, can also be used in place of price-to-book ratio.
Ratios can be compared against those for competitors or the industry average to assess whether they are too high or too low on the basis of the stock's given business fundamentals.
