"Six Simple Criteria That Guarantee
You Finding Undervalued Shares"

Introduction

Undervalued Shares is the next in a series of articles introducing you to the basics of Value Investing - the system that Warren Buffett uses to create fortunes for himself and those that follow him.

In the previous article in this series you were introduced to a few more basics of Fundamental Analysis such as Dividend Yield, Dividend Cover, Price/Earnings Ratio, and Stock Market Indices.

In this article you will discover what Benjamin Graham and Warren Buffett referred to as the "Intrinsic Value" of a company's share price.

You will also get introduced to a few more financial ratios that will help you better understand the jargon that you hear so often in financial publications.

So without futher ado - let's start with a look at financial ratios that are commonly used to discover undervalued shares..

"A Little Ratio Analysis Therapy"

I know for sure, that unless you are from an accountancy or banking background company Financial Statements will look like a foreign language to you.

What we try to do at Common Sense Retirement Investing is break things down into manageable chunks so that they are understandable - even for the layman (that's you and me then).

As you may, or may not know, company financial statements comprise of three elements:

• The Balance Sheet
• The Income Statement
• The Cash Flow Statement

Each of these statements contains numbers and figures, what to us laymen, could be described as gobbledegook.  There are numbers derived in each of the above statements which really mean something to the bean counters - but very little to us lay persons.

But they are a means to discovering undervalued shares.

By dividing one of these numbers by another, produces what the financial boffins call "Financial Ratios" and the detailed study of all of these ratios is aptly named Ratio Analysis.

These ratios, so derived, mean even more to the boffins especially when compared to other similar companies - such as those in the same sector.

Ratio Analysis is especially useful in determining if a particular company is in trouble. 

There are ratios that determine profitability, solvency, efficiency, margins, cash flow, net asset value, return on shareholders' funds.  There are literally dozens of these ratios and new ones being "dreamed up" all the time.

You have already witnessed a few of these ratios: the Dividend Yield, the Price/Earnings Ratio (P/E ratio or PER), and a company's Earnings Per Share (EPS).

In this article, I will briefly re-cap on those and cover what are called "Market Based" ratios.  In future articles, I will look at the three types of financial statements (as detailed above) to give you a complete picture of the various ratios that are available to you.

You may also take a look at Financial Ratios.  I make no apologies for repeating myself on this website.  You may be wired different to me, but I need to see things more than once for them to "stick" in my mind.

In the image below you can see what information is readily available.  The share's name, the price, whether that share moved up or down in the period under consideration, the high and low for the past year, its Yield, the P/E ratio, and the volume of shares traded.

It's all self-explanatory except for maybe the last column - Volume.

Volume is probably the least understood of all stock trading parameters, and this website devotes a lot of webspace in its understanding.  For now though, just accept the numbers.  This article is primarily about undervalued shares and how to identify them using key ratios.

Volume, will however, play a huge part in assessing a stock's activity. But that is a topic for another day.

The Financial Times share listings

"Price Earnings Ratio (PER) and
Earnings Per Share (EPS)"

This is  ratio that you should be familar with.  I have referred to it elsewhere on this website.

However, I do like to repeat myself as I am of the opinion that it helps to ram home the meaning of something if it has not been fully understood the time around.

And, it might be expressed in a slightly different format.

With that said, let's start with a basic definition.  The Price-Earnings Ratio, abbrviated to P/E or PER, is a basic method of valuing a share.  It's very easy to calculate - simply divide the price of a share by its earnings (per share).

[Where the Earnings Per Share (EPS) are the net profits that are attributabel to the ordinary shareholders divided by the number of shares in issue].

The equations are:

Price Earnings Ratio = share price / Earnings Per Share

Earnings Per Share = net income / number of issued shares outstanding

Where the share price is the close of day price for the previous day. This is the price you would see in the picture above.

Net income is the profit due to shareholders after the deduction of tax and minority interests. This figure is to be found in the company income statement (or profit and loss account).

Issued shares outstanding are shares that have been issued and are publicly traded. This can also be found on the income statement in a not to the accounts.

You will discover in a later article and on the blog, how easy it is to search for these parameters using nothing more than an app on your mobile phone.

Do not concern yourself with where to get all this information.  If you have joined a Self Invested Pension Provider - the platform that will be made availalbe to you will have all this data.

"Dividend Yield"

The Dividend Yield (DY) - or just simply 'Yield' - is another ratio that you will have come across before.  But here's a re-cap for you.

It is defined as the percentage of dividend paid to shareholders to the share price. Yield will always be expressed as a gross figure.

The equation:

Dividend Yield as a % = gross dividend per share x 100 / share price

The Dividends for the last finanical year are used.

As you can see from the picture above, dividends are quoted alongside other share data.

"Market Capitalisation"

The first, and probably most fundamental quantity, is Market Capitalisation (MC). It is how the stock market values a company.  It is simply the total number of outstanding shares in issue multiplied by the current market price.

Here's the equation: 

Market Capitalisation  =  issued shares outstanding  x  current share price

The number of ordinary shares at the end of the year should be used.  The number of shares used to calculate Earnings Per Share (EPS) should NOT be used as this is normally derived from the average for the year and not the most recent number.

The correct figure is usually found in the notes to the accounts.

You may be thinking: "What's all the fuss about Market Capitalisation?"  The simple answer is that MC is an indicator of the company's overall value and that will determine which index to which it will be included and what weight it may carry within that index.

Almost all stock market indices are weighted by capitalisation - the bigger the company, the bigger the weighting in the index. Companies therefore want to see their MC as high as possible.  Yes, they like the status and the prestige but practically, they want to be included in index-tracking products which in turn means that they will be sought after by funds and large investors.

Market Capitalisation is also a more useful figure to use in other ratios, rather than calculate such on a per share basis.  See 'Price To Sales Ratio' below.

As an example:  a company with 10 million shares outstanding and with a current share price of £3.50 would have a Market Capitalisation of: 10,000,000 x £3.50 = £35 Million

The Market Capitalisation of a company on its own is very little information.  But ...

... taking this one step further - if Market Capitalisation were to be compared to the company's annual sales - a completely new ratio is revealed.

The Price To Sales Ratio (PSR)

The Price To Sales Ratio (PSR) is the result of dividing a company's Market Capitalisation by their annual sales.

Here's the equation:  Market Capitalisation / Annual Sales

Annual Sales may also be referred to as Turnover and it would be the last reported sales figures that are used in the calculation.

The figure can be found on the company's Income Statement.  In our fictitious example, the company turned over £20 Million of sales.

Therefore, the PSR for this hypothetical company would be: £35m / £20m = 1.75

When trying to find undervalued shares the PSR was once very popular (late 1990s) then it fell out of favour and now it seems to acquiring support again.  But as always, no one single parameter is meaningful on its own.  It MUST be used in conjunction with other indicators.

Having said all that, the general consensus is that a PSR of less than 1 is considered to be a sign of cheapness.  That is, the shares are cheap (undervalued).  A PSR greater than one, is maybe a sign of an expensive (over-priced) company.

But beware, I know of several great companies that have a PSR way greater than 1 - a PSR greater than 3 is not unusual, and, on its own does not necessarily mean that you have uncovered undervalued shares.

"Enterprise Value"

Enterprise Value, mostly abbreviated to just EV, modifies the Market Capitalisation depending on how much cash and debt the company has.  If a company has more debt than cash - then the EV of that company is increased.  If a company has more cash than debt then its EV is decreased.

Here's the equation:

EV  =  (Market Capitalisation  +  Total Debt)  -  Total Cash

Total Debt is the long and short term debt issued or owed by the company and its subsidiaries - items such as bank loans, overdraft, bonds, long and medium term loans either secured or unsecured.

Total Cash would be cash in the company's bank account(s) and any liquid assets (assets that can be converted into immediate cash).

As an example: our fictitious company has a Market Capitalisation of £35 Million, short-term debt of £10 Million, long-term debt of £10 Million, total cash of £5 Million and will therefore have an Enterprise Value of:

£ 50 Million = £35 Million + £10 Million + £10 Million - £5 Million 

OK you might say - so what?

There is a difference between Market Capitalisation and Enterprise Value.  They both have a similar function - but the difference being that EV can be used to compare different companies that exclude interest paid or interest received.  It therefore allows you to compare companies without regard to their capital structure.

The Enterprise Value To Sales Ratio

And very similar to the previous section, Enterpise Value can be used in conjunction with other parameters to reveal more ratios.  One such ratio is the Enterprise Value to Sales Ratio.

The equation is: 

Enterprise Value To Sales = (Market Capitalisation + Total Debt  -  Cash) / Annual Sales

In our example company then, the EV to Sales Ratio would be:

(£35m + £20m - £5m) / £20m = 2.5

As with the PSR discussed above, the EV/Sales ratio is also easy to calculate and can be a very useful indicator.  The EV/Sales indicator is recognised as a consistent indicator - for all sectors.

A little common sense (which is what this website likes to use), should tell us that what a company sells i.e. its Annual Sales, has just got to be a good measure of its success and one would think, anotherway to find undervalued shares.

Using a company's Enterprise Value in conjunction with sales makes a lot of sense.  As discussed earlier, companies with high borrowings look more expensive than those with low borrowings.

As highlighted above, a company with a PSR less than 1 could be looking cheap, and allowing for most companies to have some debt, maybe a EV/Sales ratio of around 1.3 would suggest that company offers good, long-term value.

"Price To Book Ratio"

A company's Price To Book Value (P/BV) is the ratio obtained when the share price is divided by the Book Value of the shares.

Where 'Book Value' is the net assets attributable to shareholders.  It might sometimes be called: 'net tangible assets', 'shareholders' funds' or 'stockholders' equity.'  But whatever the terminology, Book Value will be used as a per share quantity.

The equation is:

 Price To Book Ratio = Share Price / (Shareholders' Equity / Number of Shares in Issue)

For our fictitious company this would equate to:

 0.583 = 3.50 / (£60m / 10m)

Taking a view on Book Value is always subjective. In most cases minority interests and goodwill are excluded. 

Also, how are values placed on property values and listed/unlisted investments? A common convention has to be set up so that when comparing different companies, there is a level playing field established.

The P/BV ratio works well for companies that have a lot of tangible assets but starts to get complicated if a lot of intangible assets, such as goodwill, are involved. 

The subject of Book Value will rear its head again when the ratios of 'Return on Capital Employed' and 'Return on Equity' are discussed later when Balance Sheets are dealt with in more detail.

"EV/EBITDA"

EBITDA is an acronym for: earnings before interest, tax,depreciation, and amortization.  Quite a mouthful.

Financial boffins have come up with this ratio in an effort to value a company by comparing one measure of market value (EV) with another (EBITDA - which is derived from the income statement).

The equations:

EBITDA = pre-tax profits + interest paid + depreciation + amortiztion

EV/EBITDA = market capitalization + net debt / EBITDA

The Enterprise Value has 5 elements:

• Issues shares outstanding
• share price
• total debt
• cash

EBITDA is a company's operting profit after adding back depreciation and anortization. It can be calculated from the company accounts.

In our fictitiouscompany EV/EBITDA can be calculted as follows:

Market capitalization:  £35 Million

Short term debt: £10m

Long term debt: £10m

Cash: £5m

EV: £50m

Operating profit: £10m

Fixed Asset Depreciation: £2.5m

Goodwill Amortization:  £2.5m

EBITDA:  £10m + £2.5m + £2.5m = £15m

EV/EBITDA = £50m / £15m = 3.33

EV/EBITDA is used as a means of comparing different companies that have high level of debt or a lot of cash.  It can also be used for comparing companies that make osses at net income but maybe not elsewhere in the profit ad loss acounts.

Depreciation is a means of allowing for physical assets wearing out and regularly have to be replaced. Which means that, at some point, cash will have to be used to replace those assets.

EV/EBITDA is increasingly becoming popular with stock market analysts. And could therefore figure in discovering undervalued shares.

"Price Earnings Growth"

Here's a new ratio for you.  A slight variation on the Price Earnings ratio. 

This one was made famous by the late Jim Slater.

It is commonly referred to as the PEG Factor.

It is a measure of the PER to the growth of a company. It uses the future or prospective earnings.  If a company's PER were 10 and its forecast earnings growth was 15% the PEG Factor would be: 10 /15 = 0.66

The equation would be:

PEG Factor = price earnings ratio / earnings growth (%)

PEG forecast = price earnings ratio (forecast) / % change in earnings from last year to current

Jim Slater wanted to know if what he was paying for growth was a reasonable price.  He worked out that a PEG Factor of less than one, then a share would look cheap, and the lower it was the cheaper it would get.

Other analysts were less confident.  They reckoned that PEG only worked for a certain type of company, for example, if a company was making a loss or its profits falling. They argued that it only worked well for growth companies.

"Return on Equity (ROE)"

This is a ratio that connects the Income Statement to the Balance Sheet. The comparison being that of profits attributable to shareholders with assets owned by shareholders.

A variation on this ratio is the Return on Average Equity (ROAE).

Shareholders' Equity for this ratio should include intangible and goodwill.

The equation is:

net profit attributable to shareholders x 100 / Shareholders' Equity

The higher the figure, the more value is created for shareholders. The return can either be distributed in the form of dividends or retained withing the company.

Warren Buffett likes to see this retained within the company.

An ROE of above 17% is regarded as good. ROEs greater than 25% are regarded as exceptional.  Another very good ratio for finding undervalued shares.

"Debt To Equity Ratio (D/E)"

 Debt to Equity ratio is the proportion of shareholders' equity and debt that is used to finance a company's assets.

In general and very simply, the equation for calculating D/E is:

debt to equity = debt / equity

But ... debt can be expressed in different ways. The above equation could have been shown as:

D/E = long-term debt / equity

Or simply as:

D/E = total liabilities / equity

Whichever one is used, when comparing company against company, be sure to use the same equation.

The lower the figure, the better.  And if a company has a D/E greater than 2 - give it a wide berth. One more ratio in your quest to find undervalued shares.

"Current Ratio or Liquidity Ratio"

This is probably the simplest of all ratios.

It compares current assets (stocks, debtors, and cash) with current liabilities (bank overdrafts, money owed to suppliers, tax owed, and any other short term debt).

The equation is:

current ratio = current assets / current liabilities

It may sound obvious that a good company should have an excess of assets over liabilities.

But ... there are exceptions.

Take for example supermarkets.  Cash is taken from their customers all day and every day, 24/7, but they also enjoy healthy credit terms from their suppliers.  And they might only pay them in arrears.  A supermarket's buying power gives it a source of short-term working capital.

Exceptions apart - normally, assets would exceed liabilities.  Ideally, a company's current ratio should be between 1 and 2.

"Warren Buffett's Mentor and Value Investing"

You might be thinking, why are we now shifting from finanical ratios to a different topic?

A good point.  But we are still trying to idenitfy undervlued shares and there is a lot of background still to uncover.

Warren Buffett was always going to do good.  As a child he was obsessed with numbers.  And that pastime has stayed with him all his life. 

However, when it came to learning the investment game he needed a mentor - everyone does. And that mentor was a college professor by the name of Benjamin Graham.

Benjamin Graham became known as the father of Value Investing.

It was Graham that popularised Value Investing.

But it was Warren Buffett that modified it to suit today's markets.

Graham and Buffett differed in their ideas about earnings.  Graham distrusted future earnings.  Buffett favoured them.

Graham looked at past or "historic" earnings.  But he also regarded assets as being of importance.  Old fashioned maybe, but he took the view that companies needed good assets in order to secure loans. 

He made famous his "margin of safety" whereby the price paid for a share was low compared to its tangible assets.

He reckoned that the larger the Margin of Safety the better.

He thought he was right and proven by the fact that he made a lot of money.  So much so that he made up a set of rules:

• Buy shares that exhibit a high intrinsic value by trading at 7 times, or less, their reported earnings
• Only buy shares in companies which owe less than they are worth
• Only buy shares when the earnings yield is at least twice the rate of a top class corporate bond. (Earnings Yield is the reciprocal of the P/E ratio, which would be achieved by dividing a companies P/E ratio into 100. For example: a share selling at 6 times earnings would have an Earnings Yield of  100/6 = 16.66
• Buy shares when the Dividend Yield is at least two-thirds of the yield of a top class bond
• Sell if a share goes up 50%
• Sell if it hasn't achieved that 50% rise in two years
• Sell if earnings fall to a point where the P/E is 50% higher than when you bought it
• Sell if the company misses its dividend
  

Those were his rules.

Warren Buffett agreed with some of Graham's rules, but not all of them. For example: some companies do not pay a dividend at all.  His Berkshire Hathaway company has never, ever paid out a dividend.

Also, Buffett did not like to sell a fundamentally sound company.  Expecially if it had risen 50%. 

Buffett has been proved the more correct of the two.  Graham made a lot of money.  But Buffett has made a heck of a lot more. He knows how to identify undervalued shares.

"So ... What Is The 'Intrinsic Value' Of A Share?"

A true value investor will want to value any business before he buys.

And valuing a stock can be a tricky pastime since the price of a stock swings between optimism and pessimism and can therefore be subjective.

Value investors will buy their stock from pessimists and sell them to optimists. [Remember the Warren Buffett quote: "Be fearful when others are greedy and be greedy when others are fearful."]

As a value investor you will want to buy when the market price is below the true value of the share i.e. when the crowd are pessimistic.

Typical Business Cycle

Look at the diagram to the right.

The overall trend of the market, or share, is up.  But, the share price will gurte between highs and lows - or peaks and troughs as shown.

At the peaks, the market is said to be over-bought, and at the troughs it is said to be over-sold.  These over-sold and over-bought situations offer the value investor to buy when the shares are over-sold (pessimism) and sell when the shares are over-bought (optimism).

In other words, the market over-reacts - both ways.  It can over-value a stock and it can under-value a stock.  And the stock will gyrate between the two extremes. The markets react for several reasons:

• the company announces disappointing earnings
• the industry or the market as a whole undergoes a "correction"
• the announcement of bad news
• the business cycle
• the economic cycle

The actual calculation of intrinsic value goes into fairly advance mathematics and is beyond the scope of this article.  However, six criteria (there are others) for finding undervalued shares are listed below.

"Six Criteria for Finding Undervalued Shares"

When looking for undervalued shares, there are many criteria to consider but the following six are simple, easy to find, and a very good indiction that you have found an value.

Each one has been described above and a good way of finding them if you're trying to analyse a particular company is to get a copy of the company accounts or check with your pension provider who should be able to supply you with the correct information - online.

As a rough guide, consider six criteria when valuing a stock.  If all six of these criteria tick positive, you may be on to something.  Here's the list of the six criteria:

1. P/E Ratio
   - this is described above and elsewhere on this website.  However, it is good to compare the P/E ratio of the company you have under surveilance with another from the same sector.  It should go without saying that you would not consider a company that loses money.
   
   Generally, a P/E of under 12 would be encouraging, but as mentioned just above, every sector would be different, and P/E of under 6 would not be unusual.
   
   
2. Price to Book Ratio P/B
   - as with the P/E ratio above, this is described earlier in this article. A P/B below 1 would indicate that a share is trading at less than the value of its assets.
   A P/B ratio of greater than 1, would indicate a share is trading at more than the value of its assets.  You would obviously want a share's P/B ratio to be less than 1
   
   
3. Price To Earnings Growth Rate PEG
   - the best results for calculating PEG come when you use a 5 year earnings growth rate. PEG is a good metric for a company that is seeing rapid growth.
   
   
4. Return on Equity ROE
   - the annualised net income to shareholders' equity.
   - 17-20% is very good
   - 20-25% is excellent
   - 25%+ is outstanding
   
   
5. Debt to Equity Ratio (D/E)
   - is the total debt divided by the shareholders' equity.  The lower this figure the better. Avoid shares that have D/E greater than 2
   
   
6. Current Ratio (sometimes called Liquidity Ratio)
   - is a measure of a company's ability to pay short term and long term obligations.
   - obtained by dividing current assets by current liabilities. 
   - a value below 1 means liabilities exceed assets
   - a value above 1 means assets exceed liabilities,
   - a value above 3 signifies that a company is holding something back, perhaps too much cash
   

Summary

You may have a winner if:

• The P/E Ratio is below the sector average
• The Debt to Equity ratiio is low. Avoid if greater than 2
  
• Return on Equity is 18% or more
• Current Ratio is between 1 and 2
• The PEG Ratio below 1
  
• Price to Book Ratio below 1

Most of the information you need can be found on websites similar to Yahoo Finance.

In a Bull market it is difficult to find undervalued shares.  Bear markets are obviously easier.

Conclusion

A fairly long article.  Apologies. But ...

... we want to mention some basic basics.  Basics that have made Warren Buffett ridiculous fortunes.  And he has made his fortune by investing in undervalued shares.

We don't think the world will ever see the like of him again.  However, he will have left his legacy. 

The main point about being a Buffettologist is being able to transform your way of short-term thinking into one of long-term thinking.  We homo sapiens tend to want instant gratification - it rarely happens, at least, not consitently.

For every whizz kid that claims to be making a pile of moolah day by day, there are thousands that are losing money. Money that they can't afford to lose.

Investing for your retirement is a long-term commitment.  Investing the Warren Buffett way is tailor-made for your retirement investing.

You need to be able to identify undervalued shares and to be able to do that you must have a thorough understanding of all the basics.  This website is specifically for the layman.  If you think you are beyond all this basic stuff then good luck to you.  Go and find for yourself a few ten baggers.  This website is not for you.

The six criteria above are a very good guide in identifying undervalued shares.  When used together with any of your other research you should have a really good idea about the company you are studying - is it ripe for buying or need you wait just a little longer?

What would Warren Buffett do? The master of investing in undervalued shares.

Get a thorough understanding of how to identify undervalued shares and learn to be patient.  Warren Buffett has the patience of Job.  Look where it's got him.

Before this pandemic is over, there are going to be a lot of rich pickings for the people who know what they are looking for.  Do what Warren does - find undervalued shares, be patient, and fill your boots.

Look out for the next article in this series (Finding Undervalued Stocks) where we will cover some more of Warren Buffett's stock picking techniques. 

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