According to Charlie Munger, Warren Buffett’s highly respected colleague and co-manager of Berkshire Hathaway (BRK.B:NYSE), ‘All intelligent investing is value investing, acquiring more than you are paying for.’

Or, as Howard Marks of Oaktree Capital Management puts it, ‘It’s not what you buy, it’s what you pay, and success in investing doesn’t come from buying good things but from buying things well.’

So, what simple checks can we do as private investors to see whether stocks which catch our eye are not just good businesses but are worth more than they are selling for?

QUICK AND EASY

By far the simplest and most popular method of valuing stocks is comparing the share price to a company’s earnings, or the PE ratio for short.

Academics will argue that PEs aren’t a true reflection of a company’s growth, financial health or value, but just a short-term ratio for comparing relative value among different companies or asset classes.

That may be true, but they are also a quick and easy way of measuring what price investors are prepared to pay for a stock and the valuation metric can be applied to almost any company.

WHAT DOES THE PE RATIO MEAN?

When all is said and done, analysts’ forecasts for sales, margins, currency impact, operating costs, depreciation and even tax, boil down to the earnings per share, so the PE ratio is as good a proxy as any when it comes to measuring a firm’s progress.

Simply put, if a stock is on a PE of 10 it means you are paying 10 times this year’s forecast earnings to own its shares. Put another way, it would take you 10 years to get back your investment in the form of earnings if they stayed at the current level indefinitely.

The PE is calculated by dividing the latest share price by the expected earnings per share. As a rough rule of thumb, a PE above 20 is considered to be a premium rating or expensive, something between 10 and 20 is in fair value territory – it varies on a sector-by-sector basis – and something on a PE below 10 is cheap. Just remember that some stocks are cheap for a negative reason and deserve to be on a low PE.

A quick screening of the FTSE 350 index using SharePad and based on 12-month forward earnings shows 87 stocks with a PE ratio of less than 10, which if nothing else demonstrates the UK market is full of what would appear to be cheap companies.

At the cheapest end of the spectrum are life insurance firm Just Group (JUST), electricity producer Drax (DRX), travel group International Consolidated Airlines (IAG) and high-street banks Barclays (BARC) and NatWest (NWG) on PEs ranging from 2.8 to five times expected earnings.

In fact, all of the ‘Big Four’ UK lenders have mid-single-digit PEs, as does Standard Chartered (STAN), along with telecoms provider BT (BT.A) and tobacco groups British American Tobacco (BATS) and Imperial Brands (IMB).

On its own, this is interesting information, but it becomes even more interesting when we compare the current ratios with each company’s average rating over say five or 10 years.

Using averages taken from Stockopedia, we can see that Just Group for example is trading at less than half its five-year average PE, while BP is trading almost bang on half its five-year average and most of the banks and tobacco stocks trade at just over half their historic average PEs.

The question is, why are investors only willing to pay such a low multiple of future earnings for these stocks?

We can think of a couple of possible explanations: maybe investors think earnings forecasts are too high, and therefore the PEs are wrong, or they think these companies aren’t capable of growing their earnings, as growth is an important part of most people’s investment strategy as well as value.

HOW TO VALUE GROWTH? USE THE PEG RATIO

If growth is a concern, a quick way to measure the market valuation against expected earnings growth is to divide one by the other to create a price to earnings growth or PEG ratio.

If a company has a PE of 10 and grows its earnings by 10%, its PEG is one, while if its PE is 5, like many of the stocks in our screening, and earnings growth is 10%, the PEG ratio is 0.5 or half the expected growth rate.

A rough rule of thumb is that stocks on a PEG of less than 1 are cheap relative to the growth on offer.

Using SharePad to screen the FTSE 350 using forward growth rates throws up a rather different list of names at the bottom of the value pile than plain PE ratios.

Out go the banks, with the exception of Standard Chartered, and in come an assortment of insurers, pub groups and retailers, although like the stocks in the PE table the majority are down on the year in share-price terms.

Just Group is still the cheapest stock in the market on a PEG ratio of 0.2, while Drax looks equally unloved.

The presence of retailers Currys (CURY) and Kingfisher (KGF) suggests investors are concerned their earnings may be at risk from the cost-of-living crisis, which seems to be borne out by their weak share prices year-to-date. Having Frasers (FRAS) on the list of low PEG stocks is a surprise given it has been doing well as a business.

USING PRICE TO BOOK

As well as earnings, we can measure the value of a business by dividing the share price by the ‘book value’ or net asset value, also known as NAV.

Investors in the real estate investment trust sector will be used to using NAVs, but for ordinary equity investors it is the per-share value of the business’s net assets, which is what the company would be worth if it had to be liquidated.

Using SharePad again to screen the FTSE 350, this time using trailing 12-month price-to-book – since no-one can necessarily forecast forward net asset values – we get an intriguing combination of the first two tables, i.e., banks, telecoms, retailers and tobacco, plus Just Group, which appears to be the cheapest stock in the market whichever way we look at it.

Hopefully, we have provided investors with a short-list of stocks which at least look cheap on a couple of simple metrics and may merit further investigation.

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