Truth is, there are many ways to evaluate stocks.
Most will work.
But in today's session of #AskDrWealth, we focus on the simplest way.
That is...the simplest way for any new and aspiring investor to get off their butt and start investing...for real.
Oh and by the way, the Benjamin Graham also used this method.
Let's hop right in and discuss now;
Have...you met Ashton?
Let's begin with my favorite way to explain a concept; an analogy. I will introduce you to a guy named Ashton.
Imagine that Ashton has a house worth $1.5 million and cash worth $500,000 in the bank.
Together, these two will form his total assets of $2 million.
Like most of us we don’t usually pay all of our property in full, but finance it through a mortgage loan.
So Ashton takes up a mortgage loan of $500,000, which represents a liability of $500,000.
The question now is, what is Ashton’s net worth?
How to Calculate Net Worth?
"Net worth" is essentially: assets minus liability. Therefore, in Ashton’s case, his net worth would be a total of $1.5 million.
Net worth = Assets - Liabilities
We arrived at that number by subtracting Ashton’s liability ($500,000), from his total asset ($2 million).
The result of this would be a total net worth of $1.5 million.
Determining the Value of Stocks using the concept of 'Net Worth'
Now, let us go back to our analogy.
Let us now imagine that Ashton is for sale, hypothetically, as an asset, in the market.
You found out that he is priced at $1 million. This means you can actually buy him and own his assets and his liabilities as a package for $1 million.
With all our previous calculations, you know that Ashton’s net worth is $1.5 million. But you only need to pay $1 million. *discount alert!*
Hence, we can simply say that Ashton is a priced below his market value, and he is undervalued.
If We Treat Ashton As A Stock...
Now, let's translate the method stated above into the realm of stock investing.
Instead of using the term 'net worth', we use the term 'book value' when we analyse stocks.
Book Value is an accounting method to determine how much the company is worth.
The book value of equity is the value of a company’s assets expressed on the balance sheet.
It is defined as the difference between the book value of assets and the book value of liabilities.
Therefore, in the same vein, the 'net worth' of a stock can also be calculated using assets minus the liability.
The Simplest Way to Determine If A Stock Is Undervalued
To evaluate if a stock is undervalued, we use a ratio instead of a fixed number from the difference between the assets and liabilities.
The ratio that we will use is the PB ratio:
The PB ratio aka the Price-to-Book ratio, is the ratio of market price of a company’s shares (share price) over its book value of equity.
Essentially, this simple method determines the value of the stock by identifying if the share price is below the book value of the company.
When the PB ratio is less than one, it is essentially saying that the price is less than the book value.
It's that simple.
- If the PB < 1, you are looking at an undervalued stock,
- If the PB = 1, the stock is priced fairly,
- If the PB > 1, the stock is overvalued
5 Potential Problems that may Arise when using this Strategy
You should also be wondering by now.
"Won't stocks that pass this criterion tends to have problems?"
Afterall, why else would a stock be undervalued?
If it were a good stock, it is unlikely to be undervalued. Instead, it should not be selling below its net worth.
It is likely for low PB stocks to have the following problems:
- They are unsexy businesses or not having wide contemporary interest
- They are part of the sunset industry, which pertains to an old and declining industry
- They may incur certain losses over the years
- They may be smaller companies
- They have bad management
These are the problems that are associated with this kind of undervalued stocks.
Generally, investors tend to shun them because they don't like the problems associated with these companies.
But at the same time, they provide great opportunities for the shrewd investor.
A bonus tip for growth investors
If you are looking for stocks with the potential to grow, take note.
Growth stocks generally don't pass the "PB < 1" undervaluation test.
Instead, growth investors expect the company to be worth more in the future than what it is currently now. Hence, they are willing to pay more than its current worth.
Therefore, growth stocks tend to be overvalued most of the time.
What Stocks to Buy...As Backed by Research
Despite the problems presented above, there is a study done by researchers that could bring you hope. (paper source provided in resources section later)
They found out that when you buy very cheap stocks (i.e. very low price to book stocks), your returns will likely be higher regardless of all the problems that persist in these companies.
In a study, they compare the bottom 10% price to book ratio stocks (i.e. the cheapest 10%) with the top 10% price to book ratio (i.e. the most expensive stocks).
They compare the returns over several years, and found that on average, if you have bought the cheapest stocks by the lowest price to book ratio, you will gain 1.6% of returns per month.
However, if you've bought the most expensive stocks, you would have only gain you 0.6% per month.
Buying just the cheapest stocks based on price-to-book ratio alone will give you almost 3x more returns!
That's it for today’s episode of #askdrwealth.
You would have discovered about the simplest way to determine whether stocks are undervalued. And also seen the effective results by this method, as published by researchers.
I would urge you to not be concerned about some of the problems that you may face when looking at these companies. Some of them may not even be prominent issues. Some of these companies may just be dealing with temporal losses.
Instead, look at these as opportunities for you to finally start investing by detecting undervalued stocks and hopefully gain higher returns over the long run!
Leave a comment below and let me know if you have any questions about lump sum investing vs dollar cost averaging.
Or, if you have any investing question that you'd want me to talk about in our next video. I hope you found today's video insightful and practical for your own investments!
*Disclaimer: We are not responsible for your investing results - good or bad. Do your own due diligence. Here are some resources to help you out:
Co-Founder. Believer of the Factor-based Investing approach. Running a Multi-Factor Portfolio that taps on the Value, Size, Profitability and Momentum Factors. Quant at heart. Believe the financial industry can treat their customers better. Wants to change the world.