How should we evaluate and pick stocks? It’s an age-old question, but one of the methods that you can use is value investing. Value investing is a methodology in which you look at a company’s fundamentals and invest in companies that you think are undervalued. This makes sense if you invest in a company that’s undervalued, and the market finally realizes it’s undervalued, well, hopefully, that company’s share price will regress to its mean. When that happens, the share price hopefully goes up thus rewarding you for your research and your investment.
Here’s the problem though, with companies like Tesla which are up 694% in the year 2020, same with Square which is up 239%, and Snapchat which is up 197% to name a few. It’s safe to say that growth investing has actually outperformed value investing, especially when it comes to companies like Coca-Cola which are down 10% in the same year, and AT&T which is also down over the same period.
Frankly, since the financial crisis, growth companies have outperformed value companies especially due to a big surge in big tech. In this article, I want to explain a different type of way to look at potential investments, which is actually just a modern value investing approach. If you will, it’s a modern take or an updated method, and I’m going to explain that to you.
First, we’ll go over how value investing has been done in the past, then we’ll go over what modern value investing looks like today, and we’ll also talk about some metrics that you can pay attention to when looking at potential investments. Lastly, I’ll walk you through how to calculate these updated metrics for modern value investing.
Before we get started, I want you guys to know that this is my personal opinion and how I go about looking at different types of companies to invest in for the long term, but it’s not the end-all-be-all for investing. If you have a different type of methodology that you really like, you can also do that as well. This article seeks to educate you and hopefully entertain you, but it should not be treated as financial advice and you should always do your own research. With that being said, let’s go over the first part of this article.
What is Value Investing and How Has it Been Done Before?
Value investing as you may know it today was popularized by someone named Benjamin Graham, and if you don’t know who he is, he actually is the author of the intelligent investor. His methodology for value investing actually ended up forming Warren Buffett’s value investing philosophy which I’ll sum up for you right now.
Essentially, they would look for companies trading below their true value, and they would invest in those companies knowing that the market would have to recognize their true value over time. Ben Graham and Warren Buffett looked at metrics such as price to book value, price to earnings growth ratio, or the peg ratio as it’s known, and also current ratios back then. But times have changed, that’s not to say we shouldn’t still pay attention to things like price to book value or the peg ratio, but we should definitely update our methodology for the modern times.
How Old it Really is
To give you an idea of how old this is, when Benjamin Graham published his first book in 1949, West Germany and East Germany were formally established as nations, the NBA was in its first year, and Meryl Streep and Billy Joel were born to give you an idea. Since 2007, value investing under Graham’s philosophy has actually underperformed growth by an average of 6.1% annually.
A 14-year sample size is nothing to gloss over either, so that kind of begs the question is value investing dead? Should we just put all of our money into Tesla, Amazon, and the Shopify of the world? Not so fast, this is where modern value investing can actually come in to guide our potential investment decisions for long-term good investments.
Anyone can make money in the stock market in the short term, but in the long term, it’s actually quite hard to even outperform the S&P 500 as many top investment managers in the world know. It’s why Warren Buffett likes to tell the average investor that you’re probably better off just putting all of your money in a diversified index fund, setting it, and forgetting it.
We definitely don’t want to throw out Ben Graham’s method of value investing, but instead, there are some different types of metrics that we can pay attention to, to basically modernize the process. Ryan Gosling once said that wall street likes to make you think that only they can do what they do.
But today I want to explain to you two of the most fundamental criteria that are being used today by top investment managers such as Blackrock and Canadian firm Gluskin Sheff. Instead of price to book value, I’d like to introduce you to free cash flow yield and also return on invested capital.
Free Cash Flow Yield
Free cash flow yield is the first metric that we’re going to talk about, and it actually takes into account one of Warren Buffett’s favorite metrics which is free cash flow. It takes free cash flow and actually converts it to a percentage or a yield per share. A company could be making millions or billions of dollars in revenue, but they could be using so much cash that if they’re operating at a negative cash flow, then that’s not good. We want to be looking for companies that are operating at cash flow “positive”.
When a company is operating at cash flow positive, it just basically means that they’re making more money than they’re using, that’s always a good thing when evaluating the strength of a business. Free cash flow yield is important because if companies are strong, they don’t need to spend as much cash as they actually earn to maintain their competitive position. Warren Buffett really likes to invest in companies that have “moats”, which is just a really fancy way of saying that companies have a competitive edge over their competitors.
How Free Cash Flow Yield is Calculated
It’s actually just represented by this formula which is free cash flow yield divided by the market capitalization of the company. Generally, we want to aim for a free cash flow yield of anything over five percent, this is because the average free cash flow yield in the market is about five percent so if we can get any company that has higher than that, that’s usually a good indicator of the company’s fundamentals.
The key takeaways from Investopedia are actually the following on free cash flow yield. First, a higher free cash flow yield is ideal because it means that the company has enough cash flow to actually satisfy all of its obligations, that makes sense, it’s making more than it’s spending. Second, if the free cash flow yield is low, it means investors aren’t receiving a very good return on the money they’re investing in the company.
Let me show you guys an example of how to actually get free cash flow yield on yahoo finance by doing the following. Visit yahoo finance, look up Apple stock which is just a really good stock, and click on statistics. Navigate all the way down to their cash flow statement section, you’ll see that their leverage free cash flow trailing 12 months is $60.39 billion. That’s their free cash flow, and remember our formula is free cash flow divided by market cap.
For their market cap, if you scroll all the way up on the same page you’ll find that it is $2.14 trillion. All we have to do is divide those two together, since it was 60.39 billion, it’ll be 60.39 divided by 2104 (that’s 2104 billion) you’ll get 0.0282. Multiply that by 100 to get the percentage and you’ll get 2.82%. 2.82% is the free cash flow yield of apple. This is just one of the metrics that we can pay attention to for modern value investing when trying to determine if a company is worthy of our investment.
Return on Invested Capital (ROIC)
The next metric that we can pay attention to is actually called return on invested capital or ROIC, and that basically is the return that a company makes on its investments. When we’re investing in companies, we want to make sure that their investments are actually ROI positive because that means if they’re making money, then we’re going to be making money as shareholders down the line.
Let’s use Apple for example, if apple spent around $700 per iPhone they make including shipping, marketing, and other fees. If Apple sold each phone for $999 that means apple’s return on invested capital for the iPhone is about 29%. This is a great example of a profitable product line from Apple, but if you remember back in 1998 apple actually came out with what’s called a Hockey Puck Mouse.
The product was only on shelves for two years and then discontinued, and that’s probably because it was hard to use, and the return on investment probably just wasn’t there. ROIC is a metric that essentially ensures that a company can continue to invest in projects for now and into the future at a profitable pace.
Companies with a lower return on invested capital actually have fewer opportunities for profit because their projects are generally less profitable, so they basically have less value down the line. Return on invested capital is arguably one of the most important metrics especially when it comes to institutional investors, and that’s because it’s a really all-encompassing number based on the spending that a company does, how profitable they are will really set the stage for how competitive of an edge they have in the future.
Things to Look For in ROIC
A deep dive into return on invested capital actually reveals that many of these things are already factored into ROIC, things like the strength of their brand, economies of scale, good management teams, and competitive advantage. I can’t get as deep into the return on investing capital as I’d like to, but I’ll leave you here with a quote that I read during my research which was “why would you want to invest in a company, with the aim to make a profit on your investment when they can’t even make profits off their own investment?”
In general, when it comes to return on invested capital, I like to look for anything that’s higher than 10% consistently over three years, but it definitely differs based on the industry. To calculate ROIC yourself, you actually need to know the formula, and the formula is pretty complicated. It’s earnings before interest and tax, multiplied by one minus the tax rate, and you take all of that and divide it by the book value of invested capital. It’s definitely one of those metrics I like paying attention to when evaluating a potential stock position.
Being completely honest, unless you had some sort of financial program like Bloomberg or Capital IQ that could automatically pull these metrics for you, using these metrics in your investment decisions can be actually quite tedious. The reason is that you have to manually pull the free cash flow numbers every time from yahoo finance for example, or the return on invested capital numbers and manually input and calculate them.
Not to mention, a Bloomberg subscription can actually run you about two thousand dollars a month so imagine adding that to your Netflix, your Hulu, or your Spotify subscriptions. But if you can afford it, it’s going to be worth your investment. If you can’t afford it right now, you can put in the extra work required, it’s not that tedious though. Consider your time researching as part of the investment process, I mean this is your hard-earned money we’re talking about, you can’t just throw it into any company. It pays to do your research. Peace and Happy Hustling!