Finding Undervalued Shares

The father of security analysis was arguably Benjamin Graham.  He believed that value investment was the only real form of investment and that anything else was merely speculation.  His ideas have been adopted, modified and enhanced by the likes of Warren Buffett and similar ‘buy and hold’ investors.

So how do we calculate value?  Let’s start with the basic Balance Sheet.  In essence this lists a company’s long-term ‘fixed’ assets and short-term ‘current’ assets on the plus side.  On the negative side we take away that which the company owes, its liabilities.  This simple calculation gives us the net asset position of the company and, from an account’s perspective, tells us what the company is worth.  On the face of it this seems OK; we own this, we owe that, take one from the other and that’s what we’re worth.  So what’s wrong with that?

Well, quite a lot, really.  First off, the Balance Sheet is just a snapshot in time and that time is quite a while ago, so the information is seriously out of date by the time we can get hold of it.  Secondly it doesn’t include some things that are considered too hard to value.  How do you value the staff, for example?  In a service business the staff are probably the company’s most valuable asset and yet the Balance Sheet takes no account of them.  Some liabilities or potential liabilities might also be hidden ‘off balance sheet’.  If they’re too difficult to quantify, perhaps an outstanding legal claim against the business, they may simply be referred to in notes to the accounts.  Nevertheless, the net asset value (NAV) of a business is a reasonable starting point, but there are better ways to find a bargain.

We can look first at a fairly straight-forward ratio; the price to book-value (p/b) ratio.  This compares the share value as quoted on the stock exchange to the NAV or book value of a company.   Let’s say that a company has a NAV of £50 million and that it has 20 million issued shares.  We can calculate the NAV per share by simply dividing 50 by 20, giving us a NAV per share of £2.50.  If the price of the shares quoted on the stock market is £1.90 the p/b ratio is 0.76 (share price divided by NAV per share).  Equally, if the quoted share price was £2.85 the p/b ratio would be 1.14.  In theory therefore, a ‘cheap’ share will have a p/b ratio of less than one and would be trading at a discount to NAV, suggesting that a rival business could buy the company for less than the value of its assets.  However, (there’s always a ’but’) it might be cheap for a reason.  Just because it appears cheap doesn’t necessarily mean its good value.

One of the oldest ratios to indicate value in a share is the p/e ratio.  This is the current price of the share on the stock market divided by the last four quarters earnings per share (EPS).  So, for example, let’s say that Marks & Spencer shares are trading at 381p with an EPS of 32.3p.  Dividing 381 by 32.3 we get a p/e ratio of 11.80.  Putting this another way, you would have to invest £11.80 for every £1 of earnings.  A company with a low p/e ratio, but where the EPS has been steadily increasing over time, suggests that a company could be under priced.  When considering p/e ratios, it’s important to make sure that you are comparing similar businesses in the same sector.  No point in comparing a retail company with a mining business.

There are other ratios of course, dozens in fact, and they start to get a bit more complicated.  Let’s look quickly at a couple of them.   The Tobin’s “Q” ratio was developed by James Tobin a famous American economist at Yale University.  Tobin considered that the total market value of a company should be roughly equal to the total value of the company’s assets.  He went on to suggest that this same principle could be applied to the whole stock market.  To calculate the Q ratio you take the market value of a company and divide it by the replacement value of the firm’s assets.

If the Total Market Value and the Total Asset Value are the same, then the Q ratio equals 1.  It therefore follows that a value of less than one means that the cost of replacing the company’s assets is more than the value market value of the company.  The company is therefore undervalued and a potential takeover target. 

Finally, the Return On Investment (ROI) reflects how well a company is using its assets to generate additional value for shareholders.  This is a simple percentage calculated by dividing net profit by net worth.  If a £20 share returns £2.50 in a year, your ROI is 8%.  Naturally you want this percentage to be as high as possible.

This type of fundamental analysis is a useful starting point in evaluating shares before making any investment decision, but it’s not the whole picture.  The problem with buying shares in a bear market, when they appear to be undervalued, is that they can continue to decline because of a lack of investor confidence in the market as a whole.

This article gives a brief insight into fundamental analysis and the search for undervalued shares.  If this sparks an interest in the subject for you then the books suggested below will help to give you a greater understanding of what can be a complex subject.   As always, we strongly recommend that you take appropriate professional advice before making any investment decisions.