How to Identify Deep Value Stocks
At UGC, we use a range of valuation methods to identify potentially undervalued companies. Two key valuation ratios we often use in combination are: Price-to-Earnings (P/E) and Enterprise Value to Earnings Before Interest, Tax, Depreciation and Amortisation (EV/EBITDA) .
As we showed last Wednesday, we classify value stocks as, essentially, under-priced businesses for which the market has low expectations for the outlook of the company and as such, the shares typically trade at a low price-to-earnings multiple relative to the market and also often relative to their peers.
As a rule of thumb, we like to screen for stocks with a PE multiple below 12x, and EV/EBITDA below 10x.
In addition to screening for various quality metrics, such as, high returns on invested capital and low and sustainable debt levels, stocks trading at or below the above multiples could be possible deep value plays worthy of further investigation.
Here’s an example of one such investment we recommended.
In 2012, we recommended Microsoft (MSFT) to clients of UGC and many clients continue to own the shares today.
At the time, MSFT was trading on PE and EV/EBITDA multiples of 11x and 9x, respectively. As per the charts below, these were historically low multiples for MSFT.
(Source: stockrow.com)
(Source: stockrow.com)
In the case of Microsoft, not only was it a high quality company generating huge cash flows, but it was now trading at remarkably cheap multiples.
The company was being criticized for missing out on important trends in mobile phones, social networking and search engines, and it definitely wasn’t as “sexy” as competitors such as Apple and Amazon. However, it was generating historically high levels of cash flow and consistently increasing revenues.
(Source: stockrow.com)
Overall, the company met our valuation and quality criteria, but the underlying performance of the business was not being reflected in MSFT’s share price.
Fast forward 5 years and MSFTs share price has risen 110% versus the S&P 500 which is up 64% during the same period. Add to that MSFTs growing dividend, and you have yourself a very nice performer.
(Source: HUBB Financial)
As we noted in our last article, there appears to be some signs that a shift towards more value oriented stocks is taking place.
After 8 years of rising stocks prices, the number of deep value opportunities are dwindling. However, if you know what to look for, opportunities still exist.
If you want to learn how to invest in stocks and analyse the market to identify profitable or deadly turning points, contact United Global Capital today for a no cost, no obligation consultation on 03 8657 7640 or email [email protected] to learn about Quality, Value, Trend (QVT) investment selection methodology.
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The information contained in this article is General in nature and has been prepared without taking into account your objectives, financial situation and needs.