We have compiled an in-depth guide about value stocks, how to identify them and successfully trade with them. We’ve also approached the benefits and drawbacks of adding value stocks to your portfolio, including relevant examples.
Value Stocks Meaning
Value stocks are shares of publicly listed companies that are trading at a discount respective to their fundamentals, such as earnings, sales, and dividends. In most cases, these companies are large and well-established in their business line, holding a good financial position. Some of the most common characteristics of value stocks are low P/E ratio, P/B ratio less than 1, and high dividend yields.
Generally, firms with undervalued stocks focus on paying more dividends and maintaining their business as it is, rather than engaging in new and risky projects. However, this is not always the case, as some firms are traded at a discount because of scandals, recessions, or a negative outlook for their products and services.
Value stocks can take a longer time to increase in value, and as a result, they are better suited for long term investors, that have time and patience to wait and mark a profit. In addition, many value stocks tend to offer good dividends, so they are a better fit for traders that are looking for a passive income. However, they are considered to be riskier than growth stocks, as, in order to benefit from an increase in the share price, a firm needs to improve market attitudes towards it, but there’s no guarantee that will ever happen.
Characteristics of a Value Stock
Low Price/Earnings ratio (P/E)
One of the first things to look after when searching for a value stock is a low P/E ratio. This highlights that the share price is low comparative to the firm’s earnings.
For example, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), the holding company directed by famous value investor Warren Buffet has a P/E ratio of around 15, while at the end of 2019 it went as low as 6.81. The firm has constantly increased its book value and earnings over time, providing investors with strong yields that outpaced the S&P 500 index.
High Dividend Yield
Typically, value stocks pay good dividends. This is due to the fact that they are established firms which are in business for a long time, that have less need to invest in new and expensive projects with uncertain results.
A good example of this is Exxon Mobil Corp. (XOM), the US energy conglomerate, which will pay investors an annual dividend of USD 3.48 per share in 2020, offering a very strong 7.59% dividend yield.
Established Dividend Payments
Many companies that offer investors stable and continuous dividends over time are traded at a discount. This is a sign that they operate in a stable business line, and that can overcome crisis times with more ease.
For example, Royal Dutch Shell (RDS.A), the Anglo-Dutch energy giant, has paid a steady dividend to its investors since the 1940s, while having a P/E of around 10-15 in recent years. However, even if the company managed to keep its dividends policy through the 1980’s oil crisis and 2009 financial crisis, in 2020 it was forced for the first time in history to reduce its dividend payments, due to the uncertain economic context.
Most value stocks come from well-established companies that have a proven history of financial performance. This offers traders enough information in order to make an informed decision before investing in them.
A good example of a well-established value stock is NortonLifeLock Inc. (NLOK), the cybersecurity company behind the famous Norton antivirus software. It is currently trading at a 12-month trailing P/E ratio of just over 4.
Defensive or Boring Business Activity
Investors seeking to trade undervalued stocks in 2021 can look for companies that operate in defensive or boring business sectors, such as utilities and healthcare companies. These firms can have stable earnings and profits even during market fluctuations (both recessions and expansions).
For example, NRG Energy Inc (NYSE: NRG) is an integrated power utility company which is involved in energy production and distribution, serving almost 4 million clients. The firm’s stock is now trading at a 12-month trailing P/E ratio of just under 3, making it a good choice for a stock value portfolio.
Price-to-Book Ratio (P/B) Lower than 1
The price-to-book ratio allows investors to determine if a stock is under or overvalued by comparing the net value of a company (assets minus liabilities) to its market cap. It is an indicator of great importance for value investors because it is showing the difference between the book value and the market value of a firm’s share. The former highlights the firm’s net value and is a more prudent valuation, while the latter reflects investors perception of the firm’s prospects. As a result, value traders should seek to find a company with a P/B ratio of less than 1, as it has a higher chance of further increasing its share price in the future.
Debt-to-Equity Ratio of Less than 1
The debt-equity ratio (D/E) highlights the proportion of equity to debt used by a firm to finance its assets. A low D/E ratio means that the company is financing from shareholder equity, whereas a high D/E ratio means that it is financing by more debt. Traders that look for some of the best value stocks should try to find firms with a long-term debt (more than 12 months) that is lower than its shareholder equity.
However, investors must understand that the D/E ratio can vary between industries, and a high D/E is not always a bad sign. For example, in industries with a high proportion of fixed assets, such as airlines, energy, automobile manufacturers, and pharmaceutical companies, a high D/E is to be expected.
Rising Free Cash Flow (FCF)
Free cash flow is the amount of cash earned by a firm through its business operations after it pays for its operating expenses and capital expenditures (Capex). It is an indicator that evidences if a company can generate enough cash to fund its expenses, and if has enough left to reward its shareholders by paying dividends or through share buybacks.
For traders looking for top value stocks, this is something important, because a company that has rising FCF has good prospects to reward its stockholders in the future, thus leading to a potential increase in the share price over time.
Price/Earnings-to-Growth Ratio (PEG) Lower than 1
The price/earnings-to-growth ratio (PEG) is similar to the P/E ratio, while taking into consideration the earnings growth of the firm. This metric is highlighting if a stock is undervalued or overvalued by looking at both current earnings and their expected growth rate.
As a result, value investors must know that a share with a PEG greater than 1 is overvalued because its price is higher than the firm’s expected earnings growth. On the other hand, a stock with a PEG of less than 1 is undervalued, as the price is low taking into consideration the expected earnings growth.
How to Find Value Stocks?
The first thing that investors which seek to purchase value stocks can do is to filter them by looking after companies that are trading at a low Price/Earnings ratio, and with a Price/Book ratio of less than 1. Additionally, they can try to look after firms that operate in boring or defensive business sectors, such as utility stocks. Moreover, a stable dividend policy over the years is a good indicator of a firm that has a solid financial position and is operating in a mature business line, with less new and expensive projects to enter.
Furthermore, traders looking after value stocks in 2021 can take advantage of market recessions and scandals in order to purchase stocks at a discount. For example, due to the Covid-19 pandemic, the shares of Marriott International Inc (NASDAQ: MAR) are currently trading at around USD 120, whereas during the first pandemic wave in march 2020, they went as low as USD 60. However, investors must be aware that it can take a long time for a company to recover (if it ever does) after such an event. The scandals in which Deutsche Bank (ETR: DBK) was involved, such as Euribor and Libor manipulation, and the violation of US-Iran embargo, have kept its share prices low, at around EUR 8, as compared to their peak price of over EUR 90 in mid-2007.
Traders can spot value stocks by looking after the following parameters:
- P/B ratio less than 1;
- P/E ratio must be lower than 40% of the stock’s highest P/E over the past 5 years;
- Total book value must be higher than its total debt;
- Share price less than 67% of the tangible per-share book value;
- Share price less than 67% of the company’s net current asset value (NCAV);
- Total debt should not exceed NCAV;
- Total current and long-term debt must be less than total shareholder equity;
- Discounted Cash Flow (DCF) formula can be used to determine the fair value of a company.
Risks of Investing in Value Stocks
Negative Market Attitude
Traders that want to invest in value stocks must keep in mind that they can make a good profit only if the company has prospects to improve the market perception on it, and thus, its share price. Otherwise, it can take a long time until its reputation is fixed, and stock prices will be lagging other firms from the same industry.
For example, Boeing (NYSE: BA) is having a challenging path ahead, after two of its best-selling aircraft, the 737 Max, crashed due to software errors. As a result, after almost 2 years since all 737s Max were grounded, the company finally managed to fix the software issues, though it is still unclear if people’s perception of the company will change anytime soon.
Accounting problems represent a significant risk for any listed firm, but especially for value stocks. Questionable accounting practices can further decrease the value of a company, making it hard for it to attract financing during market turbulence.
Wirecard (FRA: WDI) is a famous recent example of questionable accounting standards. For years, the company has misled regulators, auditors and investors alike by artificially increasing its revenues. After the discovery that more than $2 billion were missing from their accounts, the company filed for insolvency.
Failure to Change
Investors that want to hold value stocks should be aware if the companies where they want to invest are updated for the industry where they operate. One of the biggest risks associated with value stocks is the failure to change and adapt business models to the current working environment.
Dependency on One Product or Service
Traders should avoid purchasing value stocks from companies that are reliant for most of their revenues from one product or service. If things go bad for its main revenue source, a value company will find it more challenging to attract new capital, even though some firms can have strong capital reserves.
Undervalued stocks usually take some time to improve their share price. However, it is not guaranteed that this will ever happen.
According to our analysis above, we’ve compiled a list of value stocks to buy in 2021:
- JPMorgan Chase & Co. (JPM)
- Citigroup Inc. (C)
- Sainsbury J (SBRY)
- Morrison (MRW)
- NRG Energy Inc (NYSE: NRG)
- NortonLifeLock Inc. (NLOK)
- Royal Dutch Shell (RDS.A)
- Exxon Mobil Corp. (XOM)
- Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B)