Value Stock Criteria
A value stock is a stock priced below what the underlying business is worth. Stocks represent companies, but stock trading can sometimes be divorced from the actual business. Stock prices are influenced by several factors that have little to do with the underlying business -- for example, the supply of and demand for shares, market conditions or investor sentiment. In extreme cases the market may drive the stock price well below the value of the underlying business. A value investor buys a stock he believes is worth less than the business it represents, waits for the market to come back and recognize the full value and sells at a profit. Investors use several criteria to help them recognize value stocks.
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Low P/E
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The price-to-earnings ratio (P/E) is the current stock price divided by the last 12 months' earnings per share. The lower the number, the cheaper the stock. To identify value, investors can compare a stock's current P/E to its historical average or to that of its peers. The low P/E criterion has drawbacks. Stocks often have high P/Es after a period of bad earnings or even losses, when their price is low, and they have low P/Es at the peak of their earnings growth when their price is high and poised to decline. A stock may also have a low P/E because the company's earnings are stagnating or falling. Investors who buy stocks on the basis of low P/E alone risk buying at the top of the market or getting into mediocre investments with little or no appreciation potential.
Low PEG
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A more useful criterion is the ratio of P/E to earnings growth rate, called PEG. It is based on the premise that a fully valued stock's P/E should equal its annual earnings growth rate. If a company grows earnings 20 percent a year, it is considered fully valued at a P/E of 20, which translates into a PEG of 1. If its P/E falls below 20 while its annual earnings growth rate remains at 20 percent, its PEG falls below 1, which indicates value. The lower the PEG goes below 1, the cheaper the stock gets.
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Hidden Assets
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Finding hidden assets on a company's balance sheet takes knowledge and skill but can lead to profitable investment opportunities. For example, a company may have valuable land on its books that it bought many years ago and still lists at the original purchase price minus the depreciation, but the land's current market value may be worth many times more. A value investor may calculate that the current value of the land per share is worth more than the entire current stock price. By buying the stock, the investor is in effect buying the land at a huge discount and in addition getting the entire company effectively for free.
Turnarounds
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A stock may fall if a company is mismanaged and produces results below its potential. A new management may be brought in to turn things around, but the stock price may still reflect the old dismal situation. An astute investor who knows what is happening may buy the stock and wait for the company to start showing improved results, which would cause the stock price to rise. This approach is often the basis of many private equity funds' operations: They take control of poorly managed companies by buying their cheap stock, replace the management, turn the operations around and resell the stocks back to investors at a profit a few years later.
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