There are no perfect valuation metrics, and each method has its downsides. An experienced investor must be able to figure out the right tool for the job, meaning the best method of valuation for a given investment or market, given its unique characteristics.
The relationship between value stocks and growth stocks has been an interesting long-term cycle over decades.
From 1980 to 1988, value mildly outperformed growth. From 1988 to 2000, growth mildly outperformed value. From 2000 to 2007, value crushed growth. From 2007 to present, growth has moderately outperformed value.
This can happen for many reasons. Money tends to pour into what has been doing well. When value does very well as a factor, for example, investors and institutions will happily put more money into value stocks and value funds. But eventually, the valuations on value stocks aren’t even that cheap anymore, so the strategy underperforms.
Likewise, when people get excited about growth stocks, they can reach such crazy valuations that they have nowhere to go but down because they are totally unjustified by their fundamentals, like in the year 2000.
So I would firstly consider whether we are in a Value Cycle or Growth Cycle.
There are thousands of companies out there to shift through so I tend to shortcut this by looking at the compositions of various ETFs for ideas.
The Vanguard Value ETF (VTV) and the iShares Russell 1000 Value ETF (IWD) are some of the largest value-tilted ETFs available. At the moment, they are heavily invested in financials, healthcare, industrials, consumer goods, and energy.
The biggest risk of investing in value stocks is the concept of a “value trap”.
A value trap is a company that looks cheap and is cheap, but ends up being cheap for a reason and thus the fundamentals inevitably fall apart. Maybe the company has too much debt, or a hopelessly outdated product, for example.
Some of the best value investors screen for quality to filter out those types of businesses.
An approach that has been used with success by Joel Greenblatt of Gotham Capital, which he also popularized with “The Little Book That Still Beats the Market”
Greenblatt presents an extremely simple system:
- Rank all companies by their price-to-earnings ratio (low to high).
- Rank all companies by their return on invested capital (high to low).
- Buy the top companies that have the best combination of both (low P/E, high ROIC).
This results in having a couple dozen cheap companies with high returns on invested capital, implying they have a strong business model and economic moat and are unlikely to be value traps. This formula has beaten the S&P 500 for a long time, but like many value strategies has struggled a bit in recent years compared to growth stocks.
The ETF that most closely follows Greenblatt’s type of strategy (that I’m aware of) is the Alpha Architect U.S. Quantitative Value ETF, which is not associated by Greenblatt but has a similar approach.
It applies a quantitative filtering approach to find the top 50 companies that have high ROIC, good balance sheets, and are cheap
Their international version is IVAL, which filters in a stock universe outside of the United States.
Stocks with high shareholder yields are an attractive subset of value stocks, and the Cambria Shareholder Yield ETF (SYLD) passively filters for them. The foreign version is FYLD.
The shareholder yield of a company is the sum of money it is paying in dividends, spending on buybacks, and repaying debt, divided by its market capitalization.
Studies have shown that stocks with high shareholder yields tend to outperform virtually every other classification of stocks over long periods of time.
In addition to generally filtering for value stocks, the emphasis on shareholder yield further filters for companies that have the necessarily catalyst to take advantage of its status as a value stock. In other words, like Altria, companies that pay big dividends or buy back a ton of shares, do fundamentally better when their shares are undervalued compared to when they are more expensive.
And yet like most value strategies, this one hasn’t done well over the past 5 years, even though the backtest shows it would have done amazing over a multi-decade period.
I find that qualitatively looking through companies and performing discounted cash flow analysis on them helps determine which factors are likely to do well going forward, rather than strictly relying on backtesting and quantitative filtering.
And I’m interested in factors that haven’t done well recently, rather than ones that have. Basically, I ideally want to know what the next cycle of outperformance will be, rather than focusing on what has done well recently.
There are all sorts of ratios and metrics that investors can use to determine whether a stock is undervalued relative to the investment returns it is expected to produce.
The most commonly-used one by far is the price-to-earnings ratio, often referred to as the P/E ratio.
P/E ratio of a company tells you very little by itself. You also need to know its growth rate, among other things.
For example, if a stock has a P/E ratio of 10 but is stagnating or shrinking, that might not be a very good investment. On the other hand, a stock that is growing tremendously but has a P/E ratio of 40 might still be an exceptional investment. Clearly, we need to factor in growth.
The famous mutual fund manager Peter Lynch popularized the “PEG ratio” as one of his key stock valuation methods.
You can further improve this with the dividend-adjusted PEG ratio. Stocks that pay dividends usually grow at slower rates, but their dividend makes up for that. The standard PEG ratio doesn’t factor in dividends though.
The dividend-adjusted PEG ratio (which is what I prefer), adds the current dividend yield to the growth rate. In other words, if a company is growing earnings at 8% per year and pays a 3% dividend yield, then you plug 11% into the PEG equation as the growth rate.
For example, consider a stock with a P/E ratio of 16. It is growing at 8% per year and pays a 4% dividend. The PEG ratio would be 16/8, which is 2. However, the dividend-adjusted PEG ratio would be 16/12, which is 1.33, which makes it correctly look a lot more attractive.
There is a range of appropriate dividend-adjusted PEG ratios for companies, depending on how risky they are and what your realistic target rate of return is. As a general guideline, an investor would do well to be skeptical of buying stocks with a dividend-adjusted PEG ratio above 2.
The gold standard for valuing stocks or anything that produces cash flow is discounted cash flow analysis. Pretty much everything else is a shortcut of that method.
The cyclically-adjusted price to earnings ratio, better known as the CAPE ratio or Shiller P/E ratio, is a longer-term calculation for the P/E ratio of a stock or stock market. Useful for knowing where a stock stand in relation to it’s peers.
There are a lot of other valuation metrics available than the ones listed here, including the dividend discount model or the equity risk premium model, as two examples.
Discounted cash flow analysis is the closest thing an investor has to a universal valuation method for anything that produces cash flows, but even that requires some human assumptions and decisions for inputs. These various methods are all short-cut ratios or metrics that are worth being aware of for most investments, and many of them are easier to apply on a broad scale.