The top value stocks trade lower than their financial fundamentals suggest

Finding top value stocks is among the most profitable strategies of successful investing.

High-quality “value stocks” are reasonably-priced stocks, if not cheap, in relation to its sales, earnings or assets. Investors hold onto them because they expect that other investors will recognize their value and push up the share price.

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How to pick top value stocks

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.

High-quality value stocks like these are difficult to find, even when the markets are down. But when you know what stocks to look for, you can discover them. We employ three financial ratios as a useful guide to spotting them:

Price-earnings ratios: The p/e is the ratio of a stock’s market price to its per-share earnings. We start by calculating each p/e ratio using the most recent financial data. But we then go on to analyze the “quality” of the earnings. For instance, we disregard a low p/e ratio if it is due to a one-time capital gain on the sale of assets, since the gain temporarily puffs up the “e”. Similarly, we add back any one-time earnings write-offs, so we don’t miss out on stocks that would have had low p/e ratios if not for one-time write-offs.

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.

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.

Price-cash flow ratios: Cash flow is essentially earnings without factoring in non-cash charges such as depreciation, depletion or the write-off of asset 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. Cash flow is actually 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 a measure of the cash flowing into a company less cash outlays.

Top value stocks tip: Be wary of any value stocks with an unusually high dividend yield

Investors should avoid judging a company based solely on its dividend yield (the percentage you get when you divide a company’s current yearly payment by its share price). That’s because a high yield can sometimes be a danger sign rather than a bargain. For example, a dividend paying stock’s yield could be high simply because its share price has dropped sharply (because you use a company’s share price to calculate yield) in anticipation of a dividend cut.

Top value stocks may only be cheap due to hidden problems

I learned this lesson when one of my earliest value investments collapsed. It was cheap in relation to its asset value, but its asset value shrank drastically after it wrote down the value of its inventory.

My loss on the stock was big enough to hurt at the time. But it was a cheap way to learn a valuable lesson. It kept me from making far more expensive mistakes later on, when I had more money to invest.

If a stock seems like an exceptional bargain in relation to earnings or asset values, it may suffer from hidden risks. The stock can plunge when those problems begin to take their toll.

Academic studies suggest that on average, value investing produces better results than growth investing. But these studies mostly look back on what would have happened in a particular historical period, if you followed a particular set of rules. Most distinguish between growth and income investing by looking at average p/e’s (per-share price-to-per-share earnings ratios). They assume high p/e’s are a marker for growth stocks and low p/e’s for value stocks. As any serious value or growth investor can tell you, it’s more complicated than that.

If you balance and diversify your portfolio as we recommend, it should include both growth and value selections. In both areas, you should avoid extremes.

How have you selected top value stocks for your portfolio? Were our tips helpful to you? Share your story with us in the comments.