Three main examples can illustrate the relationship between price and value. Investors need to understand the overarching principle: invest only when there is a disparity between price and value. If the price equals the value or the future value, the investment is fairly valued, implying a lower chance of being materially or consistently profitable for the investor.
If the price exceeds the investment’s value or future value, it is overvalued, implying higher expectations for the optimistic and higher risk for the not-so-optimistic. What causes stocks to be overvalued to begin with? It can be attributable to many reasons, but usually it stems from the market overlooking key aspects of a company’s fundamentals for future financial performance, or from market noise.
If the value or future value of an investment exceeds its current price, then there is an investment opportunity, because any rational investor would want to purchase a stock for a discount. What is the value of a company, then? If this were easily definable, it would be a simple formula investors could use to succeed.
The value of an investment or stock is subjective. The more an investor reads and attempts to understand a company’s business, the better they should be able to define what “value” is for the company. For example, the net interest margin would be a key ratio for determining a bank’s value. In contrast, the same ratio would not be suitable for, say, an F&B company.
See also: Understanding yields in stock investing
However, certain ratios should be used to determine the value of most, if not all, companies, and these are ratios about the company’s fundamentals. As a guide, the company’s revenue, net income, and cash flow should be used, as these are key financial figures for every company. A combination of these and company-specific factors should be used to determine the company’s value.
If investors want to go the extra mile, they can also incorporate factors that determine the company’s future value, such as expectations or forward ratios, since revenue, net income, and cash flow are all historical. Additionally, investors need to be cognizant that price-to-value growth should be used for a fairer comparison, and, if possible, over multiple periods, as discussed in the previous part of this series.
The three main examples that will be discussed are: when value growth is positive but price growth is negative; when both value and price growth are positive; and when both value and price growth are negative. The premise for all these scenarios is that value growth exceeds price growth.
See also: Understanding price and value in the context of investing, Part 1
1. Value growth is positive, but price growth is negative
This is the easiest one to determine that the investment is undervalued. If the value of an investment continues to grow positively but its value keeps declining, it is very likely undervalued.
There, however, might be a catch. If a company’s value keeps growing over multiple periods, but its share price stays flat or declines, there must be a reason keeping the price depressed. Investors need to find out the reason, whether it makes sense, and whether it is likely to persist. Sometimes, this may be a misunderstanding or market noise. In fact, it is obvious why a stock hasn’t risen in price when its fundamentals are growing consistently; hence, filtering for these types of stocks would be the first step for investors seeking undervalued companies.
Once the investor has determined that a stock is undervalued in this scenario, the investment strategy should be based on the magnitude of the disparity between the stock’s price and its value growth. If the average growth in price for both company A and company B is –10% over a period, but the average growth in value for company A is 10% and company B 50% over the same period, then an investor should invest more in company B because it carries less risk, or more certainty that it is undervalued.
There is a saying that “past performance is not indicative of future results”, but in this case, we are merely accounting for past performance that was not rewarded or recognised. In other words, the disparity between value and price reflected in undervalued stocks is the buffer or risk that investors do not need to take for an investment. This is sometimes referred to as purchasing a stock at a discount because even if the value declines, there is still a buffer or risk which investors would have accounted for.
2. Value growth is positive, and price growth is also positive
This is likely how most stocks are, because the logical thing to do is to invest in companies that have grown and are expected to continue growing in value. Generally, these companies seem to be trading normally, and investors seeking undervalued stocks often miss them.
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The focus here would be on accurately and thoroughly determining a company’s value. Given a company’s price and price growth, the challenge is to determine what constitutes its value or future value. Although the financial indicators are significant, the company’s key business metrics are likely more important. This does not mean that ratios involving revenue, net income and cash flow growth should be ignored altogether. Still, they should be prioritised less, because the market, to a certain extent, has already recognised their positive financial performance through price growth.
Further, there should be greater emphasis on the company’s future or expected performance, since its past performance has already been recognised. For these types of companies, analysis methods such as discounted cash flow (DCF) might be suitable, along with forward or expected financial ratios.
Again, the investment strategy should focus on the magnitude of the disparity between the company’s price growth and its value growth. The larger the disparity, the higher the potential returns. Investors also need to be more mindful and disciplined in updating their understanding of what the company’s value comprises, particularly after every major business update and results announcement, because although the company’s price may reflect positive value growth, it may not truly reflect the company’s actual value.
3. Value growth is negative, and price growth is also negative
These types of companies are almost always extremely risky to invest in, but the payoff, if done correctly, can be extremely significant or just meet expectations. The former usually involves turnarounds, in which the value growth turns positive after a major change in the company’s business and/or management, and the latter involves companies expected to fail but whose net assets are attractive enough to justify the investment.
An example would be a company with price growth of –30% over a period, but value growth of –20%. Technically, it appears to be undervalued, but is it truly undervalued?
In both examples of a turnaround and expectation of winding up, it is not advisable to have a significant part invested in these companies as part of one’s portfolio, simply because the risk might be overbearing.
However, turnarounds may not always be successful, so a company can continue to experience negative value growth, which unsuccessful turnarounds can further worsen. At this point, an investor should look at a company’s net assets, or book value. On paper, this is what an investor would receive if a company were wound up or liquidated.
If the price of a stock is $1.00 but its book value is $5.00, it might be strategic to buy this company because, after settling all its liabilities and selling what it owns, a shareholder might be able to obtain $4.00 in profits on paper.
As easy as it sounds, however, firstly, a company needs to liquidate all its assets and wind up, which may or may not happen. The company can continue to operate at a loss and dwindle its net assets or book value to the point where it may even turn negative. Secondly, there may be many legal and practical issues, such as trading suspensions and delistings, before the book value is returned to shareholders. Thirdly, and most importantly, the book value, or net asset value, of a company should be taken with a pinch of salt because, when selling assets to wind up, a company usually sells them at discounted prices, often known as fire-sale prices.
Sometimes investors may get more than they bargained for, but they need to be extremely careful, especially with the issues mentioned.
Read part one here.
Disclaimer: This article is strictly for infor- mation purposes only and does not con- stitute a recommendation, solicitation or expression of views to influence readers to buy or sell stocks, including the stocks men- tioned. Any personal investments should be made at the investor’s own discretion and/or after consulting licensed invest- ment professionals, at their own risk. The author of this article does not hold or own any stock featured in this article or have a vested interest in it at the time of writing.
