The three pitfalls of value investing

Value investing buying stocks when they're underpriced by the market is one of the few investment strategies that consistently works over the long run. But it's not a painting-by-numbers exercise. You can't just input data into a stock-screening tool and blindly buy the results. The risk is that you end up buying stocks that are cheap for a good reason. Here are some of the pitfalls of three classic value strategies and how to avoid them.

Low price/earnings (p/e) ratios

The price/earnings (p/e) ratio of a stock is very simple to compute just divide the share price by earnings per share (EPS). The lower it is, the cheaper the stock. But just buying a stock with a low p/e is no guarantee of success. A low p/e could be the result of various problems, such as:

Low growth prospects: the price of a stock is a function of its future profitability. Companies in declining industries with falling profits should trade on low p/es.

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Fiddled figures: the denominator of the p/e ratio EPS is based on accounting earnings. Although a company has to meet with accounting standards when stating its profits, there is much scope for manipulation. Companies with aggressive accounting policies are probably best avoided and should trade on low p/es.

Peaking earnings: a cyclical company such as a housebuilder may have a low p/e because its profits have peaked and are set to fall as the business cycle turns. Although it is time-consuming, it is better for investors to compute p/es for cyclical companies using an average of five or ten years' earnings and compare this ratio over time.

Low tax charges: be wary of companies with low p/es and low tax charges. If the low tax charge is temporary and begins to rise, profits can fall and the p/e rise. Where possible, compute the p/e on the basis of fully taxed EPS.

Debt: consider two companies, A and B. Each has £100m of assets, trading profit of £10m and identical growth prospects. A has no debt (£100m equity), but B finances its assets with £50m of debt and £50m of equity. Assuming tax rates of 25%, interest costs of 6% and both market caps equally stated equity. A has a p/e of 13.3 (£100m/£7.5m) and B's is 9.5 (£50m/£5.25m). But can B really be cheaper than A? This is where the enterprise p/e ratio comes in handy. Unlike a normal p/e, this factors in company debt levels. By taking the enterprise values (debt + equity) of A and B and dividing by the after-tax (but pre-debt) operating profits, we can see that the p/es are the same at 13.3 (£100m/£7.5m), which makes sense

High dividend yields

Dividends represent tangible returns that are independent of the stockmarket. Buying shares with a high dividend yield can be a good investment strategy (especially if dividends are reinvested), but you should also look at the following:

High payout ratio/low dividend cover: a high yield may result from a company paying out most of its profits in dividends, resulting in a low level of dividend cover (net profits divided by dividend payments). This suggests the dividend could be unsustainable if business conditions deteriorate. Also, if a firm is paying out most of its profits, it means they're not being reinvested to grow the business. As a rule, you want shares with dividend cover of two times or more.

Look for growth potential: without dividend growth, the returns from a high-dividend yield strategy are unlikely to be stellar.

Buy stocks with a high free cash-flow yield: From an accounting perspective, dividends are paid from profits, but in reality they require sufficient surplus cash flow. Free cash flow represents the cash left over for dividends after non-discretionary spending, such as interest, tax and capital expenditure. Buying stocks with a high free cash-flow yield as well as a high dividend yield may prove to be a conservative and fruitful strategy. Free cash dividend cover of 1.5 to 2 times is desirable (see Tim Bennett's video tutorial for more on EPS and free cash-flow yield.

Low price-to-book (p/b) value

This strategy involves buying a company for less than its accounting book value (or shareholders' equity) and was used to great success by value investors such as Benjamin Graham. Key points to remember here are:

Book value is an accounting measure: it may or may not be a relevant indicator of commercial value. To be a successful practitioner of low price to book (p/b) valueinvesting you need to be able to assess the liquidation value of assets on the balance sheet, ie. how much money would be raised if all the companies' assets were sold tomorrow. This may be easy if most of the assets are cash, but stocks, debtors and fixed assets can be harder to value. Many company book values have large proportions of intangible assets that are difficult to value.

Poor businesses aren't worth book value: asset values are a function of the cash flows they produce. Investors can check the reality of balance sheet asset values by calculating a company's return on capital employed (ROCE). As a rough rule of thumb, a company with a ROCE consistently below 10% may have assets that are impaired and need writing down to more realistic values.

Focus on earnings power values (EPVs) instead: this is where you calculate the sustainable profits of a business and value it as a perpetual cash flow. For example, if a business has sustainable profits of £100m and you require a return of 10%, it is worth £1bn (£100m/10%). If you can buy the business at a significant discount to this value, you may have a good value investment.