The top value stocks are inexpensive and likely to rise over time, but you need to choose carefully.

Top value stocks are reasonably priced, if not cheap, in relation to its sales, earnings or assets. They are perceived by investors as undervalued, and have the potential to rise.

When you look for stocks that are undervalued, 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.

When getting into value stock investing, it’s easy to think that stock prices vary between predictable extremes of high and low. If this was so, all you’d have to do is buy value stocks low and then sell high to make money.

In fact, though, what might stand in your way is if you succumb to the wide swings between greed and fear that affect many investors.

When greed dominates investor thinking, investors focus on profits they can make, and they downplay their fear of loss. This leads them to take more on risk. When risk backfires, costly surprises follow.

On the other hand, when fear dominates, investors focus on and exaggerate risks. This can stop them from accepting sensible risks. Many stay on the sidelines until greed takes over again, and risk is high. Then they jump into the market.

When your primary focus is to buy low and sell high, you can wind up doing just the reverse. You may spend too much time out of the market when values are attractive. You may spend too much time in the market when risk is high. You may compound your error by focusing on risky stocks, in hopes of making up for lost time and missed profits.

Investors usually start looking for top value stocks by using a few basic ratios

We employ three financial ratios for spotting top value stocks:

1. Price-earnings ratios: The p/e is the ratio of a stock’s market price to its per-share earnings. Up to a point, the rule on p/e’s is “the lower, the better”. However, a suspiciously low p/e can signal danger rather than a bargain. But a p/e around 10.0 often represents excellent value, assuming there are no danger signs such as a failure to keep up with the competition, or signs that the company has made an expensive mistake with an unwise major expansion or acquisition. A low share price in relation to earnings may mean earnings are falling or about to fall. That’s why it’s crucial to look at p/e ratios in context. We check to see if other financial ratios confirm or contradict the value of this popular ratio.

2. Price-to-book-value ratios: 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 gives you a rough idea of the stock’s asset value. This ratio captures a “snapshot” of an instant in time, and could change the next day. When we find a stock with a low price-to-book value, we look to see if the price is too low, or if its book value per share is inflated. Often, we find that the stock price is too low. But, sometimes, the company’s assets are overpriced on the balance sheet, which means they may be in danger of being written down.

3. Price-cash flow ratios: Cash flow is actually a better measure of a company’s performance than earnings. Simply put, it’s earnings without factoring in non-cash charges such as depreciation, depletion or the write-off of assets values. Cash flow is particularly useful in valuing companies in industries in which depreciation and depletion charges are based on the historical value of assets rather than the current value. This occurs in industries such as oil & gas and real estate. As with any financial ratio, you have to look at it in context.

Also, analyse these financial factors while looking for top value stocks:

1. 5 to 10 year history of profit. Companies that make money regularly are safer than chronic or even occasional money losers.
2. 5 to 10 years of dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
3. Manageable debt. When bad times hit, debt-heavy companies go broke first.

Identify these safety factors while looking for top value stocks:

1. Industry prominence if not dominance. Major companies can influence legislation, industry trends and other business factors to suit themselves. Minor firms, on the other hand, don’t have that power.
2. Geographical diversification. Canada-wide is good, multinational better. There’s extra risk in firms confined to one geographical area.
3. Freedom to serve (all) shareholders. High-quality value stock picks must be free of excess regulation, free of dependence on a single customer, and free from self-dealing insiders or parent companies.

How do you look for top value stocks? Have our tips been helpful to you? Share your experience with us in the comments.