Financial ratios are a key part of finding value stocks, but there are a lot more company and industry factors you need to look at

Virtually all successful investors have some form of a value investing strategy, at least for a portion of their portfolio.

When you look at finding value stocks, it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele. Furthermore, we recommend using a few basic ratios.

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Finding value stocks to invest in includes looking at these ratios

There are two basic steps to finding undervalued stocks: first, develop a rough list of stocks that meet your basic criteria and direct you to investigate further; second, do more in-depth analysis of these stocks—starting with examining their financial data.

Here’s what to look for:

Price-earnings ratio: The p/e is the ratio of a stock’s market price to its per-share earnings. Generally, the rule is that the lower the p/e, the better, and a p/e of less than, say, 10 represents excellent value. We calculate each p/e ratio using the most current financial data. But we also verify the “quality” of the earnings. This means we factor out low p/e’s that arise if a company sells off assets or subsidiaries and records a large one-time gain. (That inflates the p/e, and is not representative of its true ongoing operating earnings.) Similarly, we add back any one-time write-offs so we don’t miss any stock that has a low p/e on an ongoing basis.

Remember, though, that a low p/e can be a danger signal. A low share price in relation to earnings may mean earnings are falling or about to fall. That’s why we don’t view p/e ratios in isolation. Instead, we check to see if other ratios confirm or contradict their value.

Price-to-book ratio: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share is a rough approximation of the actual value of the company’s assets. It represents a “snapshot” of an instant in time, and could change even the day after the financial statements are issued.

Note that asset values on a company’s books are the historical value of the assets when they were originally purchased, minus depreciation. Certain types of assets on a balance sheet might have actual market values well above historical values, as sometimes happens with real estate or patents.

When we find a stock with a low price to book value, we look to see if the price is too low, or if the book value per share is inflated. Most often, it’s because the price is too low. But, sometimes, assets are about to be written down. In that case, the stock should be avoided.

Price-sales ratio: This measure represents the ratio of share price to per-share sales and is not as widely known as the p/e, or price/book ratio. Still, it can be even more important in pinpointing an undervalued stock. Sales are more stable than earnings, so a company’s p/s ratio can tell you more about it than its p/e. Sales are less subject to manipulation by management or distortion by accounting rules. When a company’s shares trade for less than its per-share sales, it may be cheap. On the other hand, only a handful of companies are worth more than say, three times sales. But companies that deserve a high p/s may prove to be your best investments.

Price-cash flow ratio: Cash flow can actually be a better measure of a company’s performance than earnings.

While reported earnings are subject to accounting interpretation and can be restated in later years, cash flow is really a measure of the cash flowing into a company less cash outlays. Simply put, it’s earnings without taking into account non-cash charges such as depreciation, depletion and the write-off of intangible assets over time. Cash flow is particularly useful in valuing companies in industries where depreciation and depletion charges are based on the historical value of assets, rather than current values — industries such as oil & gas and real estate.

Use these three tips to help you in finding value stocks for your portfolio

• Determine if the company has freedom from business cycles. Demand periodically dries up in “cyclical” businesses such as resources and manufacturing. You can hold some value stocks from those sectors, but look as well for companies, especially in manufacturing, that have broad product lines or products that are indispensable.
• Review a company’s dividend record over the last 5 to 10 years. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying stocks, you’ll avoid most frauds.
• Review a company’s finances going back 5 to 10 years. The types of investments we focus on have a history of profits going back for at least that long. Companies that make money regularly are safer than chronic or even occasional money losers.

Use our three-part Successful Investor approach for finding value stocks as well as other top stocks to invest in

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

In the current market downturn, what value ratios have you found yourself most focused on?