Value investing and the price earnings ratio

Because the price earnings ratio uses price as an input, it’s no help determining the value of a company. Value investing is the way to go.

Price earnings ratio, intrinsic value, net tangible assets, dividend discount model.

With so many ways to measure the quality and value of a company, you can easily become bamboozled when it comes to deciding which ones are worth adding to your share portfolio.

Rather than an over-reliance on performance indicators, like the popular price earnings ratio (P/E) used by many investors, Skaffold favours the value investing methodology, which has been adopted and refined by the world’s most successful investor, Warren Buffett.

While the price earnings ratio – (current) share price / (historical) earnings per share – tells you what the market is prepared to pay for the current earnings per share of a company, it reveals nothing of the intrinsic value of a company, either now or in the future.

Intrinsic value

Buffett’s exceptional track record proves convincingly that intrinsic value – the sum total of the business’s worth based on earnings, dividends, equity and debt – is the key to distinguishing superior stocks from their lower quality counterparts. To Buffett, the hallmark of a superior stock is the quality of its underlying business.

Skaffold is founded on the value investing principles practiced by Warren Buffett. Skaffold advocates that companies capable of growing their intrinsic value are also more likely to provide increasing capital growth to an investor’s portfolio – which is what investing in the share market is all about.

While it’s never an exact science, Skaffold arrives at an intrinsic value range by undertaking ‘fundamental’ analysis. This involves looking at a company's financial statements over time and making an assessment of its management, markets and growth potential. A closer look at intrinsic value will show you why it’s vital to calculate when deciding which stocks to buy (or sell).

Invest in businesses, don’t trade stocks

One of the touchstones shared by value investors is the desire to understand businesses and not just treat the share market like a casino governed by share price momentum.

Governed by more short-term drivers, share prices can vary enormously over a year, whereas business fundamentals are less volatile.

Be a contrarian investor

To capitalise on market volatility, value investors have to become contrarians. Attractive opportunities are often thrown up when market sentiment negatively influences short-term price movements rather than long-term fundamentals. Remember though, a company’s valuation can also change as new information comes to light.

It’s equally important for you to understand that sooner or later, a stock’s share price will converge with its intrinsic value. That’s why alarm bells should ring when a company’s share price significantly overtakes (or lags behind) its underlying performance or intrinsic value (aka full value). As an informed investor you need to understand that the gap between share price and intrinsic value won’t last forever. So while price remains an important performance ratio, your decision to buy or sell within a value investing model should always be based on underlying quality.

Focus on the very best top stocks

Value investors seek to buy exceptional businesses when their share prices are trading at a significant discount to intrinsic value.

This strategy is more likely to grow the long-term value of your share portfolio than buying a lower quality business, with fewer opportunities for future growth, at a cheaper price. But the closer the share price gets to a stock’s intrinsic value, the greater the risk of overexposure to any single stock.

Buying shares in a poor performing business will almost guarantee you lose money over time.

QBE Insurance Group (QBE) serves to illustrate this point. In 2007, as soon as business performance started to decline, so did the company’s intrinsic value, and surprise, surprise the share price followed suit.

Skaffold Line chart presents QBE’s share price and intrinsic value, as estimated by Skaffold

By estimating forecast intrinsic valuations for each (profitable) stock – derived by earnings, dividends, equity and profit forecasts from consensus analysts – Skaffold’s value investment software can help you decide whether a buy or sell decision makes sense. But given that intrinsic value calculations are only ever an estimate, it also makes sense to apply a Safety Margin to that valuation to allow for uncertainty.

Skaffold’s patent-pending Quality Aerial View plots companies based on the quality of their balance sheet and current safety margin.

The best stocks to invest in are located in the top right corner of the Aerial View – they’re bright green.

Skaffold’s Quality Aerial View plots ASX-listed companies based upon their Skaffold Quality Score and Safety Margin

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