Visualizing Value Investing
is inspired by the strategies and methods laid out in the national bestseller What Works on Wall Street
by James O'Shaughnessy. In it, the author presents a series of value factors that have historically outperformed the broader market. With Theory A we visualize the deciles of these value factors so that investors can intutively and easily shortlist a set of stocks for further research.
The use of decile buckets for visualizing is both simple and intuitive because it instantly shows how cheap or expensive a stock is relative to the broader market without being affected by absolute changes.
Below is a breakdown of various value factors and examples on how to use our tool.
Price to Earnings Ratio
Price to earnings
is considered by some to be the most important factor since earnings reflect how much money the company is currently making and how much investors are willing to pay for each dollar of earnings.
The higher the P/E ratio, the more investors are paying for earnings and the more expectations there are for future earnings. High P/E stocks are thus prone to major crashes whenever these future expectations are disrupted.
This includes natural disasters like earthquakes or tsunamis, man-made disasters like wars or geopolitical mismanagement, broad macro conditions like tightening interest rates, or even just internal mismangement that squanders the potential of the business model.
Stocks that have very high P/E ratios often have unrealistic expectations far into the future despite also often having the largest short-term price appreciation. They are in effect supported not by fundamentals but by narrative.
EBITDA to Enterprise Value
is short for “earnings before interest, taxes, depreciation, and amortization”. It is a measure that is neutral to a company’s capital structure and capital expenditures and judges a company based its "pure" cashflow. As an example, it can help compare companies with different debt levels.
EV or enterprise value
is a more comprehensive alternative to market cap for measuring the total value of a company by including factors such as debt, minority interests, and preferred equity. In short, it is the theoretical takeover value of the company.
ignores capital structure, it is more useful for comparing within the same industry that have similar capital structures. Comparing this metric between say a software company with low debt requirements vs a retail company with high debt requirements may not be very informative.
A high EBITDA/EV indicates a cheap stock that has healthy cashflow relative to its total theoretical value. A low ratio indicates a company that is in greater danger of cashflow issues during unexpected events.
Price to Cashflow Ratio
ratio is the ratio of a stock’s marketcap to its operating cash flow or net income. Some value investors prefer it to earnings since it is more difficult to manipulate using different accounting methods. It is also useful as a measure for cash flow positive companies that are asset heavy and have large non-cash expenses such as depreciation that suppress its earnings valuation.
A stock with a high P/CF is expecting a significant increase in future cash flow. As it is projecting far into the future, there is a higher risk of unforeseen changes which can impact the cash flow. A stock with a low P/CF may not be expecting any significant changes in future cash flow. This may make it a more stable investment, but may also mean that there is less potential for capital appreciation.
Note that this factor has a bias to utility stocks since they are asset heavy and have large stable cash flows.
Price to Sales Ratio
While ratios like P/E or EBITDA/EV measure a company’s money making potential and economic health, the Price to Sales
ratio can be thought of as a measure of a company’s popularity as it measures how much investors are willing to pay for per dollar of sales which is agnostic to whether or not the company is currently profitable.
A stock with a high P/S ratio is being sold at a large premium relative to its revenue. Often the company has little to no earnings or is unprofitable because it is focused on growing and expanding. Their stock price tends to go up as long as they can maintain that growth but often crash once growth falters and have to focus on profitability.
Low P/S stocks are “unfashionable” and out of favor with the market. They are under-followed, have low trading volumes and generally lack the attention of institutional investors. This is a good thing for value investors who seek bargains and are willing to do their own research.
Price to Book Ratio
A low Price to Book
ratio indicates that a company is being valued close to its liquidation value. Such a stock has little room to fall.
However most company’s have many intangible assets such as brand recognition or growth potential. A company with a very low P/B ratio is often a company that is cheap for good reason as it is judged as having few future prospects.
When using the P/B ratio it is prudent to ask whether or not its ratio is justified. If it is too high, then it may be a red flag as its valuation is far in excess of the company’s liquidation value. If it is too low, it may be unfairly discounted and worth another look.
Many value factors on their own do not give a complete picture of the long term value of a stock. However when combined, they can serve as a way to filter for high quality stocks that are trading at a discount.
Many value screens should be combined with a “liveliness” factor. While a bargain store may have cheap items, it takes experience and domain expertise to actually pick out the undervalued items that are currently underappreciated.
One simple way is via price momentum by filtering for stocks that in the top 30% of 6 month price appreciation. This potentially signals that there is growing interest and that the stock is not a dead value trap. However investors should apply their own measures of liveliness on a case by case basis.
Value investing is typically thought of as the default boring path. However in our experience growth investing based on meme stock momentum is often the default because that is what saturates the media and creates a feeling of safety and familiarity. While these stocks are great for exciting speculation, they are often disapponting in the long run due to unsustainable narratives.
At Theory A we hope to make value investing more accessible to everyone and offer an alternative to the madness of crowds. To learn more, follow us on Twitter
or contact us at email@example.com
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