"Someone is sitting in the shade today because someone planted a tree a long time ago," is one of my favorite quotes from legendary investor Warren Buffett. Buffet certainly believes in patience and discipline.
He was also known to say, "Price is what you pay. Value is what you get." Growth and value are two different styles of investing. Growth stocks may be relatively expensive but are projected to have rapid growth in revenues and earnings in the future. Value stocks are priced such that they may appear to be cheap relative to their peers.
Over the years there’s been quite a bit of serious academic research analyzing and comparing the two different styles. If you compare the Standard & Poor’s 500 Index SPX, -0.07% today to the S&P 500 Pure Value IndexSPXPV, +0.14% you'll find that over the last one-,three- and five-year periods the pure value index has outperformed the S&P 500 by a significant margin.
One study titled, "Value versus Growth: The International Evidence" was done by Dr. Kenneth R. French and Dr. Eugene F. Fama and was published in The Journal of Finance in 1998. They analyzed global stock markets and found that for a 20-year period from 1975-1995, value stocks outperformed growth stocks by 7.68% a year and that value stocks outperformed in 12 of 13 major markets including the U.S.
Another study by Michael W. Barad at Ibbotson and Associates done over the 1969 to 2002 time frame also found that value stocks outperformed and further showed that small company value stocks performed better than large caps. The Ibbotson study, titled, "A Comprehensive Set of Growth and Value Data" was limited to U.S. stocks and didn't include foreign equities.
There are several common metrics for measuring a stock's valuation. One of the most common is the price-to-earnings ratio, where the price of the stock is divided by the company's earnings, the lower the number the better.
Another is the price-to-book ratio, where you calculate the book value of the stock, then divide the book value by the price. If a stock you were analyzing has a price-to-book ratio of 1, that would mean that the company is trading at its book value. A ratio of 2 would mean that it is trading at twice its book value. If it were to be trading at a ratio less than one that would indicate that the current price is actually less than the company has invested in itself.
You can get some good insight into a company by analyzing its cash flow. It's pretty tough to stay in business without cash flow. One metric used is price to cash flow, where you divide the company's price by its cash flow. Another measure of cash flow is known as free cash flow. To obtain the free cash flow, you subtract the company's capital expenditures from their operating cash flow to determine how much free cash they have available to work with.
A good measure of a company's valuation is known as the price-to-free cash flow ratio. To get that number we divide the price of the stock by the free cash flow. For the price of the stock you don't use the price per share, you use the market capitalization of the company which is the total value of the company and is obtained by taking the price per share of the stock and multiplying it by the number of shares outstanding. A lower number here can mean that the stock is trading at a reasonable value. When comparing stocks you should also compare the valuations to the average for that industry.
Long-term investors should understand the value style and consider using it as part of your equity portfolio.
Thanks for sharing valuable information.
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