While LearnVest's philosophy is to buy mutual funds and ETFs that help you diversify and spread your risk, if you are set on investing in individual securities, here are some tips from our partner InvestingAnswers.
Putting his finger on this difference between price and value in stock investing is essentially what made Warren Buffett the third-richest person on earth. Today he's worth more than $44 billion.
What Buffett means is simply this: Every stock on the market trades for a certain price, but it's more important to know how much you're actually getting in return for paying that price. That's value.
To better explain, let's scale stocks down to lemonade stands. Say you want to make some money and you're deciding between buying one of two different lemonade stands to do it. Both stands are being sold by their owners for the same price--$100.
If you're thinking, "What's the difference between the two stands?" then you're already thinking like a smart investor. Let's say one stand earned $20 profit last year while the second stand earned $100 profit last year. Which stand gives you more value (i.e. more in return) for your $100 investment?
Let's look at your two investment choices: If you invested $100 into the first stand, you could earn $20 each year and make back your original investment in five years. But if you instead invested $100 into the second stand, you could make back your money in one year and start earning profit after that. That's a 20% annual return versus a 100% annual return on investment. It's clear that the second lemonade stand is a much better value.
Buffett uses a similar analysis to pick winning stocks. He practices a strategy called value investing-- essentially buying companies that have a low stock price in relation to their true value. In other words, he buys shares of a good company when it's "on sale." Over time, the undervalued stock's price will rise closer to what it's really worth, and Buffett will enjoy the gains as long as he holds on to his shares.
Buffett's track record shows value investing can pay handsomely if done correctly: the investments he chose through his firm, Berkshire Hathaway, gained an amazing 513,055% from 1964 to the end of 2011. By comparison, the S&P 500 (with dividends included) gained just 6,397% over the same stretch.
Lucky for us, almost anyone can follow this successful investing strategy. First, find a great company that has a strong brand, good management and healthy earnings. (For help finding a great company, check out The 8 Most Important Facts To Know About A Company Before You Invest.)
Then, find out if that company's stock is "on sale." These four valuation ratios used by expert investors can help you find out if the stock is a bargain based on its price and value:
1. Forward Price-to-Earnings Ratio (Forward P/E)
Let's again say you want to buy a lemonade stand. Before you make an offer, would you rather know how much profit the stand made over the past year or how much profit the stand is expected to make over the next 12 months?
The forward P/E ratio essentially tells an investor the latter information about a stock. (The similar P/E ratio compares price to the past year's profit--the first option--to find value.) You can use the forward P/E ratio to find a stock's value based on today's stock price and what the company is expected to earn over the next 12 months. [See examples of forward P/E and learn how to calculate it here.]
Save Yourself Time: Morningstar lists a company's forward P/E on its stock quote pages. As an example, you can see Microsoft's forward P/E here under the heading "forward valuation." (Note: Keep in mind that earnings forecasts are based on analyst expectations, so one analyst's forward P/E may differ slightly from another's.)
Is The Stock A Bargain? Generally, a stock is trading at a good value when its forward P/E is lower than its P/E ratio, lower than its competitors' forward P/E ratios and lower than the S&P 500's forward P/E ratio (which has historically been between 14 and 17). A stock that meets these criteria means that the company's profits are growing faster than its peers and the broad market--and/or trading for a cheaper share price.
2. Price/Earnings-to-Growth Ratio (PEG)
Let's say that someone is willing to sell you their lemonade stand for the same price it was offered at last year. On its own that may not sound like a great deal. But what if a reliable source told you with absolute certainty that the stand will make twice as much profit in the coming year as it did last year? Not only is the lemonade stand suddenly twice as valuable, the offer price sounds much more tempting. Paying last year's price for the stand to earn double the profit could mean there's potential for earning double the return on your initial investment.
That's the idea of value investing--find companies with inexpensive share prices and strong future earnings growth. You can find bargain stocks this way by using the PEG ratio, which compares a company's price-to-earnings ratio (P/E) to its expected annual earnings growth rate (G). [See examples of how investors use PEG to find undervalued stocks here.]
Is The Stock A Bargain? A stock is often considered a good value when its P/E is lower than its expected annual earnings growth rate. In other words, if a stock has a P/E ratio of 30, the company should be expected to grow its earnings by 30% or more this year. Otherwise, its stock price is growing faster than its earnings, and that could mean the stock is overvalued and headed for a correction. Look for a PEG ratio of 1.0 or less (the lower it is, the better the stock's value).
[InvestingAnswers Feature: Don't Be Misled By the P/E Ratio]
3. Price-to-Free Cash Flow (P/FCF)
You may have noticed in my previous examples that the P/E, forward P/E and PEG ratios all use earnings (also known as profit) in their analysis to find a stock's--or lemonade stand's--value. While earnings are generally a good way to measure a company's overall health, they can sometimes be manipulated with clever accounting techniques that artificially pump up a company's value. Former Enron investors know the dangers of that all too well. No one wants the Enron of lemonade stands.
Fortunately, there's a ratio that can help you find a stock's value without using earnings. The price-to-free cash flow ratio (P/FCF) compares a company's stock price to its free cash flow, which is essentially the amount of raw cash the company has left over after it pays the bills and buys the capital (buildings, property and equipment) it needs to operate. A company can use its free cash flow to expand, pay dividends or pay down debt. The more free cash flow a company has, the more it can potentially grow in value.
Save Yourself Time: Morningstar lists a company's free cash flow per share under the "key ratios" tab. Here's Wal-Mart's free cash flow per share as an example. To find a company's P/FCF ratio, simply divide the current stock price by the free cash flow per share. [See examples and learn how to calculate P/FCF here]
Is The Stock A Bargain? A stock may be a good value if its P/FCF is lower than its prior years' P/FCF ratios or lower than its competitors' P/FCF ratios. As a rule of thumb, look for stocks with a P/FCF of less than 10, which means that the company's free cash flow makes up at least 10% of its valuation. The lower a company's P/FCF, the more potential growth you're getting per dollar you invest.
4. Enterprise Value-to-Cash Flows From Operations (EV/CFO)
The P/E ratio is an investor favorite, but it has one glaring flaw: You can compare a stock's P/E only against peers that are within its industry--or you have to compare it against the entire S&P 500. The EV/CFO ratio, on the other hand, allows investors to compare the value of one company to any other company, regardless of industry, on an apples-to-apples basis.
Let's break down the EV/CFO ratio.
EV: Just as smart car shoppers don't like to pay the sticker price for cars, value investors don't always like to pay the market's stock price for companies. Enterprise value (EV) tells an investor how much it would cost to buy a company after taking into account how much debt and cash it carries. A larger company looking to acquire a smaller firm typically finds that company's EV before they make a buyout offer--ensuring a fair deal.
CFO: Cash flow from operations (CFO) tells an investor how much raw cash a company's core business generates. The higher the CFO, the healthier the business. CFO makes it easier to do an apples-to-apples comparison between companies because it strips out depreciating assets and tax rate implications that vary from business to business.
Combined, EV and CFO make up the versatile EV/CFO ratio that can be used to compare valuations of several different types of companies.
Save Yourself Time: Yahoo Finance calculates a very similar valuation ratio for you--the EV/EBITDA ratio. Here's Procter & Gamble's EV/EBITDA, for example. [See an example of how to calculate EV/CFO here]
Is The Stock A Bargain? A stock with an EV/CFO ratio that is 10 or less represents a very good value. That essentially means that it would take less than 10 years for the company to pay for itself (i.e. buy all of its outstanding stock and pay off all its debts) if it were to use the operating cash it generates each year.
The Investing Answer: Remember, no single valuation ratio is the magic bullet that can tell you if a stock is a bargain, so use multiple valuation ratios for best results. (Hint: You can find four more useful stock valuation ratios in The #1 Rule Every New Stock Investor Needs To Know.)
Think of each of these ratios as a different "test" that measures if a stock is overpriced, fairly priced or undervalued. The more of these tests you run on a stock, the better you'll be able to tell if it's truly a diamond in the rough that's ready to be snapped up--and the higher your chance of investing success.
Nothing in this article should be construed as a personal recommendation or advice. Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any investment security.