The answer to the question “How do I buy stocks?” has two parts. First, I look for companies that comply with my five revealing ratios for selecting undervalued stocks. Second, I conduct an overall stock investment analysis of the company and assign a buy rating. In this article, I will focus on the first part of the answer – the five revealing ratios for selecting fundamentally undervalued stocks.
5 Revealing Ratio’s for Selecting Fundamentally Undervalued Stocks
There are several thousands of listed companies to choose from, so I have identified a set of revealing ratios to limit the number of companies that could potentially be included in my stock portfolio. These ratios ensure that I can only choose financially healthy stocks as the selection process is based largely on the analysis of the company’s balance sheet.
Ratio #1: Current Ratio
Current Assets / Current Liabilities = (Minimum) 1.5
The current ratio informs us whether a company can pay back its current liabilities (short-term debt and payables) with its current assets (cash, receivables, and inventory). A ratio below 1 implies that the company is unable to pay off its current liabilities with its current assets. Current liabilities include all the company’s liabilities that are due within twelve months, while current assets include all the company’s assets that are expected to be converted into cash within twelve months.
Companies with a current ratio below 1 often need to raise additional funds from capital markets or sell assets to pay off their debts and have sufficient cash for future working capital needs. They may also need to arrange additional funds to finance their expansion plans. As a result, their share price may decrease in anticipation of arranging the required financing. Therefore, I avoid companies with a low current ratio for my stock portfolio. If a company in my portfolio has a current ratio that decreases to below 1.5 over time, I will liquidate the position unless I have concluded that the decrease is only temporary.
Note: When selecting undervalued stocks in sectors other than mining and oil and gas, I use the quick ratio instead of the current ratio for the first ratio. The minimum value for this ratio should also be 1.5. The difference between the current ratio and the quick ratio is that the quick ratio subtracts inventory value from current assets before dividing by current liabilities. Inventory is excluded because it often takes months or even years to turn it into cash, which is rarely the case in the energy and mining sectors. Additionally, I feel comfortable with companies that hold mineral inventory, especially for the most scarce minerals.
Ratio #2: Price to Tangible Book Value
Market Price / Tangible Book Value per Share = (Maximum) 0.5
Tangible Book Value is calculated as: Total Equity – Goodwill – Intangibles
Ratio #2 is an interpretation of the margin of safety principle. The margin of safety principle advises investors to only buy undervalued shares in the current stock market, i.e. buy them at a discount. The tangible book value already provides a margin of safety by subtracting goodwill and intangibles from the book value. However, my second revealing ratio demands that I only purchase shares of companies at a minimum of 50% discount to their tangible book value. This discounted value is only the entry point for my initial buy order, and I tend to purchase more of a company’s stock when the share price decreases even further. If you are unfamiliar with the margin of safety principle, I recommend reading my book summary of The Intelligent Investor by Benjamin Graham, which according to Warren Buffet is the best book on investing ever written.
Note: Of course, when a company’s balance sheet doesn’t report goodwill and or intangibles, I adjust this ratio to the Price to Book Value, which outcome should also be maximum 0.5.
Ratio #3: Solvency Ratio
Total Tangible Equity / Total Tangible Assets = (Minimum) 0.5
Total Tangible Equity is calculated as: Total Equity – Goodwill – Intangibles
Total Tangible Assets are being calculated as: Total Assets – Goodwill – Intangibles
Generally, I prefer companies that strive to keep their solvency ratio as close to 1 as possible, which signifies that they are minimizing their debt levels on their balance sheets. Such firms retain the flexibility to increase their debt load when seeking to scale their profitable operations, or to repurchase shares from the open market when their valuation is low. Investing in companies that have a minimum solvency ratio of 0.5 signifies a strategic move towards defensively managed stocks. These stocks offer a substantial safety cushion in the event of economic downturns.
Especially when it comes to mineral exploration companies, I prefer to see a low amount of debt level on their balance sheets, as these companies often do not generate profits. For these exploration companies, my minimum requirement for the Solvency Ratio is 0.8. However, when a company begins to bring a project into production, it is logical for its debt level to increase as it needs to finance the costs to develop the project into a producing asset. Additionally, more established companies with producing assets typically have a higher relative debt level compared to exploration companies, as long as their producing assets are generating profits or expected to do so in the near term. For producing mineral resource stocks, my minimum requirement for this solvency ratio is 0.5 too, as this value indicates that the company can still arrange extra leverage to its balance sheet if it is confronted with unforeseen problems.
Note: Of course, when a company’s balance sheet doesn’t report goodwill and or intangibles, I adjust this ratio to Total Book Value / Total Assets, which outcome should also be minimum 0.5.
Ratio #4: Price To Earnings Ratio
The P/E Ratio is calculated as: Market Value per Share / (Diluted Normalized) Earnings per Share (EPS) = X
While I will not establish a strict minimum or maximum boundary for this profitability metric, I consistently calculate this ratio to stay informed. Drawing from the wisdom of Warren Buffet, the P/E ratio should ideally not exceed 15, as this would correspond to an annual return of roughly 6.67% (calculated as 100/15). This rate of return would theoretically double your investment approximately every 11 years.
A lower P/E ratio may suggest that the company’s shares are undervalued relative to its earnings, potentially signifying a good investment opportunity. Conversely, a high P/E ratio may imply that the stock is overpriced, or that investors are expecting high growth rates in the future.
However, while a lower P/E ratio could indicate an undervalued company, it is crucial to cross-reference it with the company’s cash generation capabilities. A company with a low P/E ratio but weak cash flows may be facing difficulties generating profits from its operations, which could impact its ability to maintain or grow earnings in the future. On the other hand, a company with a low P/E ratio and strong cash flows might be a good investment as it shows the company is undervalued relative to its earnings, and also has the ability to generate a healthy amount of cash from its operations.
Ratio #5: Dividend Yield
Dividend Yield is calculated as: Dividend per Share / Market Value per Share * 100% = Y
Also for this ratio, I haven’t set a rigid minimum or maximum threshold, although I find it desirable when profitable companies share a portion of their earnings with shareholders, particularly when they are unable to reinvest these profits effectively themselves.
A higher dividend yield ratio indicates a higher dividend payout relative to the investment’s cost, which can be attractive to income-seeking investors. While a significantly higher ratio may suggest an undervalued stock, it could also hint at underlying problems with the company’s financial stability or the sustainability of its dividends. Therefore, it’s crucial to always consider the dividend yield in the context of your broader due diligence process.
In summary, I can conclude that the companies which comply with my 5 revealing ratio’s:
- have enough liquid assets to be able to pay their current liabilities;
- are valued at a current market price which clearly undervalues the assets mentioned on their latest balance sheet;
- have a strong balance sheet with a low debt level and a cushion for unexpected rough times;
- ideally, not only generate profits but also share a portion of these earnings with their shareholders.