Anyone who has ever tried to value a company has used some rules of thumb when conducting the financial ratio analysis. For me personally, these form a base upon which various screens and shortlists are structured. Looking for undervalued stocks can at times feel like looking for a needle in a haystack, and these rules of thumb can come in very handy to ease the screening process and get to the shortlist faster, so we can quickly commence the joyous process of reading the appropriate financial statements and conducting a deeper due diligence on each stock.
So what kind of financial ratio analysis we are talking about? Which rules of thumb?
Let's start with some key valuation ratios.
Insisting on a Low P/E Ratio may Cause You to Miss Greatly Undervalued Stocks
Price/earnings ratio is one of the cornerstone ratios upon which many a screen is built. A typical value investor is very likely to add a P/E ratio filter in his or her screen. The rule of thumb that is used in this case is to keep your P/E ratio under 15. Some aggressive value investors (or more conservative, depending on your point of view) might filter out any stocks with P/E ratio above 10.
There are cases where a company may see a temporary drop in earnings. This may be due to short-term difficulty, an unusual non-cash charge to the earnings, or for any multiple reasons. For example, an insurance company may face a large claims payout in a given year due to a vicious hurricane. This event is statistically not likely to be repeated every year and the company otherwise is healthy. This year's earnings though are abnormally low, and hence, the P/E ratio is likely to be very large (Most sophisticated investors realize the short-term nature of this event and are unlikely to punish the stock price too much knowing that the earnings will recover quickly).
Is this stock likely to be undervalued? Chances are, it is. Temporary distress creates opportunities. The problem is that a low P/E ratio screen will filter these opportunities out.
A low P/E ratio screen still remains quite important. However, we would like to find these edge cases because most of the investors will not bother. While undervaluation is hard to find when the P/E ratios are higher, the ones that do exist are likely due to unusual situations, and can show a much larger profit potential.
An easy screen to run is to create a screen with very high P/E ratios - let's say 100 or more. One can also look at negative P/E ratio screens. With the stocks that these screens throw up, we will then go through them one by one and review their situation to find out whether an unusual situation exists (we will review these in detail), or if the stock is just normally overvalued with investor froth (we will ignore these).
Insisting on a Low Price/Book Ratio may Cause You to Miss Some Outstanding Ideas
Normally, value investors like to keep their Price/book ratio to be under 1. The idea is that there is enough equity in the business to justify the price being paid for the shares, so if something were to happen to the profits in the future, the stock price has assets backing it up and supporting it (so the likelihood of losses is lower). Other investors might be less conservative and will be okay buying a stock with P/B ratio up to 1.5. One should note that the nature of the business also dictates the correct P/B multiple one should be willing to pay. A service company, for example, that relies less on physical assets and more on human capital will sport a larger P/B ratio in normal course of business than a different company with a number of factories and equipment.
It should come as a no surprise to anyone that the book value of the assets can be at large variance with what these assets will truly fetch in the market. Sometimes the book value is overstated, in which case we may consider a stock to be undervalued where as in reality it is not. Sometimes on the other hand, the book value is understated, in which case the stock may appear to be richly valued, even though in reality it may be a great investment.
We also have situations where a company may have spent years destroying shareholder wealth to the point that the retained earnings and shareholders' equity have become very small or even negative. If the business is now in a turnaround situation and the equity can be purchased at distressed levels, this may be a great investment. A very high or a negative P/B ratio will rule out these kinds of investments.
We could screen for very high P/B ratios. Many of the stocks that come up will be anomalies that we will need to review in detail. In the past, we invested in TPL which carried almost a million acres of Texas land on its book at zero value since the land was acquired over 200 years ago and was fully depreciated by now. Given that the reason this trust exists is to monetize this land, its sole asset, it would have been curious if one did not wonder why it carried no real estate on its books, and why its P/B ratio was so high (21.52 at the time of writing).
This case though does require looking into the books in greater detail. In case of high P/E ratios, the anomalies are normally easier to find and explain. Assets may be buried in the books for years inflating or deflating the stated book value, and unless we dig deep, we may never know the fact.
Conclusion: Use the Rule of Thumb for Convenience, but Venture Outside the Box Occasionally
So, if you miss some ideas, what is the big deal? There are many more, right?
True. However, these many more ideas have a larger number of eyes already fixed on them. So, while you may find them, they may not have as great a profit potential as the stocks that keep under the radar for one reason or other. These two examples are how some stocks that may be undervalued continue to evade investors as they do not get caught in their screens.