Introduction
Investors spend a significant amount of time searching for attractive investment opportunities. Both investment research and idea generation are labor-intensive endeavors.
Stocks often become mispriced because of indiscriminate selling, which may occur for behavioral or institutional reasons. However, finding such opportunities is far from easy. In most market environments, the ratio of fairly priced securities to underpriced securities will be rather high. Thus, searching for attractive investment opportunities is often one of the most challenging steps in the investment process.
Idea generation is not a formulaic process. Most successful investors try to develop superior insights by reading voraciously, including business journals, industry publications, annual reports, quarterly reports, and other company filings. Many also speak with industry experts, corporate management, other investors, and analysts.
In addition to the hard work mentioned above, many investors rely extensively on computer-generated screening to help identify potential investment opportunities. Although professional investors may use sophisticated subscription-based screening tools, there are many free or low-cost screeners available online.
Stock screens do not replace investment analysis. They merely help narrow the universe of possible investments. A screen can identify companies worthy of further study, but it cannot determine intrinsic value, assess management quality, evaluate competitive advantage, or judge whether a company’s reported numbers reflect economic reality.
Screens are a starting point, not a conclusion.
Screening on Valuation
Because computer screens rely on accounting and market data, investors use valuation metrics as a proxy for a company’s underlying intrinsic value. These metrics are imperfect, but they can help uncover companies that may be worthy of deeper valuation work.
Other filtering criteria can be used in tandem with valuation metrics. For example, investors can screen by industry, market capitalization, profitability, revenue growth, balance sheet strength, return on capital, insider ownership, or trading history.
A well-designed screen should be broad enough to uncover overlooked opportunities but narrow enough to remove companies that clearly do not meet the investor’s criteria.
Enterprise Value-to-EBITDA
In my experience, one of the most useful screening metrics for finding undervalued stocks is the ratio of a company’s enterprise value, or EV, to earnings before interest, taxes, depreciation, and amortization, or EBITDA.
Investors calculate a company’s enterprise value by adding the company’s total market capitalization to debt, preferred stock, noncontrolling interests, and other debt-like claims, then subtracting cash and cash equivalents.
A simplified formula is:
Enterprise Value = Market Capitalization + Debt + Preferred Stock + Noncontrolling Interests + Debt-Like Claims – Cash and Cash Equivalents
Under current accounting rules, many leases are recognized on the balance sheet as right-of-use assets and lease liabilities. Investors should therefore review lease liabilities and determine whether they should be treated as debt-like obligations when calculating enterprise value, leverage, and comparable valuation multiples.
By using enterprise value in the numerator and EBITDA in the denominator, the EV-to-EBITDA ratio represents a rough measure of the cost to acquire the entire company relative to its pre-interest, pre-tax, pre-depreciation, and pre-amortization earnings. As such, the ratio is often used to identify potential takeover candidates or companies that appear inexpensive relative to peers.
EV/EBITDA = Enterprise Value ÷ EBITDA
Investors will often identify an average or median EV-to-EBITDA ratio for a specific industry and arrange the screen to show only companies trading below this ratio.
Alternatively, an investor may use an average of EV-to-EBITDA ratios from recent acquisitions within an industry. This approach can be useful when transaction data is available and comparable.
EV-to-EBITDA ratios can vary widely across industries, so investors often use this ratio in combination with an industry filter. For example, an EV-to-EBITDA screen for the retail industry might look as follows:
Industry: Retail
EV/EBITDA: Less than industry average
Market Capitalization: Above minimum threshold
Operating Income: Positive
Although EV/EBITDA is a useful screening metric, investors should understand its limitations. EBITDA ignores capital expenditures, working capital requirements, taxes, and the cost of maintaining the business. A company can appear cheap on EV/EBITDA while still generating little free cash flow.
For that reason, EV/EBITDA is best used as an initial screen, not as a final valuation conclusion.
Price-to-Earnings
Although the price-to-earnings ratio, or P/E ratio, is the more commonly cited valuation metric, it is generally inferior to EV-to-EBITDA for comparing companies with different capital structures.
Because the P/E ratio uses accounting earnings after interest expense, it can be difficult to interpret when comparing firms with different debt levels. A highly leveraged company and a conservatively financed company may have very different net income even if their operating businesses are similar.
However, screening on the P/E ratio can still lead to interesting stocks.
P/E Ratio = Stock Price ÷ Earnings Per Share
P/E ratios can vary greatly by industry, but for many industries, a P/E ratio below 10 is often considered low. Investors should be careful, however. A low P/E ratio can indicate undervaluation, but it can also indicate declining earnings, cyclical peak profits, weak business quality, accounting distortions, or market skepticism about the company’s future.
Most standard stock screeners allow investors to screen on trailing twelve-month earnings and forward earnings. Trailing earnings are based on the company’s most recent reported results. Forward earnings are generally based on analyst estimates and management guidance.
To increase the effectiveness of the screen, I often prefer to look for companies with both low trailing P/E ratios and low forward P/E ratios. To weed out companies with declining sales, I often further define the screen to filter for low P/E stocks that also have positive sales growth over a multi-year period.
A typical low P/E screen might look as follows:
Trailing P/E: Less than or equal to 10
Forward P/E: Less than or equal to 10
Five-Year Sales Growth: Greater than 0%
Operating Income: Positive
Investors should also consider using normalized earnings rather than reported earnings. Reported earnings may be affected by nonrecurring gains, restructuring charges, impairments, tax adjustments, acquisition-related expenses, or other unusual items.
Normalized earnings attempt to estimate the company’s sustainable earnings power.
The purpose of a P/E screen is not to identify automatic investments. The purpose is to identify companies whose market price may be low relative to earnings power and therefore worthy of further research.
Price-to-Tangible Book Value
A company’s tangible book value is generally the carrying value of the company’s assets, excluding intangible assets such as goodwill, minus the company’s liabilities.
The price-to-tangible book value ratio, or P/TBV, is the stock’s price divided by the per-share amount of the company’s tangible common equity.
Price-to-Tangible Book Value = Stock Price ÷ Tangible Book Value Per Share
Many investors view this ratio as a rough proxy for a company’s liquidation value per share. Thus, screening for stocks selling below a P/TBV of 1 can help uncover companies that may be selling below the accounting value of their tangible net assets.
The thought behind this screen is that balance sheet values may understate the value of certain assets. For example, real estate carried at historical cost may be worth more than its balance sheet value. However, this is not always the case. Inventory, receivables, equipment, and other operating assets may be worth less than their carrying values in a liquidation or distressed sale.
Under current U.S. GAAP, inventory measurement depends on the inventory method used. Inventory measured using methods other than LIFO or the retail inventory method is generally measured at the lower of cost and net realizable value. Inventory measured using LIFO or the retail inventory method is generally measured at the lower of cost or market. Investors should therefore be cautious when assuming that balance sheet inventory values represent liquidation value.
The usefulness of P/TBV depends heavily on asset quality. The more liquid a company’s assets, the more reliable the P/TBV ratio is as a valuation metric. The less liquid or more specialized the assets, the less reliable the ratio becomes.
For example, P/TBV is widely used for financial companies, such as banks and insurance companies, because their assets are often composed largely of financial instruments, loans, securities, and other items that may be more directly related to book value. Even then, investors must analyze credit quality, loan reserves, unrealized gains and losses, interest rate exposure, capital adequacy, and other factors.
For industrial, technology, consumer, and service businesses, P/TBV is often less useful. Many valuable businesses have significant internally generated intangible assets, such as brands, software, customer relationships, data, distribution networks, and organizational knowledge, that may not appear on the balance sheet.
Since persistent operating losses can erode a company’s value, I often pair a low P/TBV screen with additional criteria requiring positive operating earnings.
A typical P/TBV screen might look as follows:
Price-to-Tangible Book Value: Less than or equal to 1
Operating Earnings: Positive
Operating Cash Flow: Positive
Debt-to-Equity: Below industry average
This screen may help identify statistically cheap companies, but it must be followed by careful analysis. A company selling below tangible book value may be undervalued, but it may also be a poor-quality business destroying capital.
Other Sources of Investment Ideas
In addition to stock screeners, two other sources often help investors uncover potential bargains:
- Insider transactions; and
- 52-week low lists.
Both sources are easily accessible by individual investors. Like screens, they should be treated as starting points for research.
Insider Transactions
A company’s officers, directors, and large shareholders must file disclosures with the SEC when they purchase or dispose of shares. These filings are generally made on Forms 3, 4, and 5 through the SEC’s EDGAR system.
Given that insiders are often well situated to understand the company’s prospects, identifying meaningful insider purchases can help investors identify potentially attractive investment opportunities.
Insider purchases may be more informative than insider sales. An insider may sell shares for many reasons, including diversification, taxes, estate planning, liquidity needs, or scheduled trading plans. But when insiders purchase shares with their own capital, they may be signaling confidence in the company’s prospects or the attractiveness of the current market price.
Investors should pay attention to several factors when evaluating insider purchases:
- The size of the purchase relative to the insider’s existing holdings;
- Whether multiple insiders are buying;
- Whether the purchase is open-market or part of a compensation-related transaction;
- The insider’s role and history with the company;
- The company’s valuation and recent price action; and
- Whether the purchase appears meaningful relative to the insider’s wealth and compensation.
A small purchase by one insider may not be meaningful. A large open-market purchase by a knowledgeable executive, especially when combined with purchases by other insiders, may deserve further attention.
Investors can find insider transactions through SEC EDGAR, SEC insider transaction datasets, company filings, and many financial data services.
52-Week Low Lists
Most major financial publications and data services publish lists of stocks trading at 52-week highs and lows. Many value investors review lists of stocks trading near their 52-week lows in search of bargains.
Occasionally, the market overreacts to a negative news event surrounding a company, creating an opportunity for investors to profit from an eventual recovery in price. A stock reaching a 52-week low may indicate excessive pessimism, indiscriminate selling, tax-loss selling, investor capitulation, or temporary business difficulties.
However, a 52-week low is not itself evidence of undervaluation.
Many stocks trading near 52-week lows deserve to be there. The company may have deteriorating fundamentals, excessive debt, declining industry prospects, poor management, weak competitive positioning, or permanent impairment to earnings power.
Investors using 52-week low lists should ask:
- Why has the stock declined?
- Is the problem temporary or permanent?
- Has intrinsic value declined as much as the stock price?
- Is the balance sheet strong enough to survive the downturn?
- Are insiders buying?
- Is free cash flow stable or improving?
- Does the company have a durable competitive position?
A 52-week low list can generate ideas, but it should not substitute for business analysis, valuation, or risk assessment.
Combining Screens
The best stock screens often combine several criteria rather than relying on one metric.
For example, a value investor might combine valuation, profitability, balance sheet strength, and insider ownership criteria into one screen:
EV/EBITDA: Below industry median
P/E Ratio: Less than or equal to 12
Free Cash Flow Yield: Greater than market average
Debt-to-EBITDA: Below industry average
Five-Year Sales Growth: Positive
Operating Income: Positive
Insider Ownership or Insider Buying: Present
This type of screen can help eliminate companies that are statistically cheap for obvious reasons, while still identifying potentially undervalued companies.
Another investor might focus on asset-based value:
Price-to-Tangible Book Value: Less than or equal to 1
Operating Cash Flow: Positive
Debt-to-Equity: Conservative relative to peers
Current Ratio: Adequate
Insider Buying: Present
The specific screen should reflect the investor’s strategy. A deep value investor, a quality value investor, a small-cap investor, and a distressed investor will likely use different screens.
The important point is to avoid treating the screen as a mechanical answer. A screen narrows the field. The investor must still perform the research.
Limitations of Stock Screens
Stock screens are useful because they can quickly sort through thousands of companies. However, they have important limitations.
First, screens depend on data quality. If the underlying data is wrong, stale, incomplete, or distorted by accounting items, the screen results may be misleading.
Second, screens rely on reported accounting numbers. These numbers may not reflect economic reality without adjustment.
Third, screens often miss qualitative factors. Competitive advantage, management quality, capital allocation skill, industry structure, customer concentration, regulatory risk, and technological disruption are difficult to capture in a simple screen.
Fourth, screens can create false confidence. A company passing several numerical filters may still be a poor investment.
Finally, many investors use similar screens. If a simple screen is obvious, the results may already be widely known. The opportunity may exist not because the screen found something hidden, but because other investors are avoiding the company for reasons that require deeper analysis.
The investor’s edge, if one exists, usually comes after the screen, not from the screen itself.
Conclusion
Finding attractive investment opportunities can be very challenging. To assist in this endeavor, many investors rely on computer screens to filter the investment universe.
Valuation screens such as EV/EBITDA, P/E, and price-to-tangible book value can help identify companies worthy of further research. Insider transactions and 52-week low lists can also help investors find situations where market prices may diverge from underlying business value.
However, screens are only a starting point. They cannot determine intrinsic value. They cannot assess business quality. They cannot evaluate management. They cannot distinguish temporary problems from permanent deterioration.
A good stock screen should lead to better questions, not automatic conclusions.
For value investors, the real work begins after the screen identifies a company worth studying.
Sources
Heins, John, and Whitney Tilson. The Art of Value Investing: How the World’s Best Investors Beat the Market. Hoboken: Wiley, 2013.
