In the stock market, the equivalent of a stock being cheap or discounted is when its shares are undervalued. Value investors hope to profit from shares they perceive to be deeply discounted.
Investors use various metrics to attempt to find the valuation or intrinsic value of a stock. Intrinsic value is a combination of using financial analysis such as studying a company’s financial performance, revenue, earnings, cash flow, and profit as well as fundamental factors, including the company’s brand, business model, target market, and competitive advantage. Some metrics used to value a company’s stock include:
- Price-to-book (P/B) or book value, which measures the value of a company’s assets and compares them to the stock price. If the price is lower than the value of the assets, the stock is undervalued, assuming the company is not in financial hardship.
- Price-to-earnings (P/E), which shows the company’s track record for earnings to determine if the stock price is not reflecting all of the earnings or is undervalued.
- Free cash flow, which is the cash generated from a company’s revenue or operations after the costs of expenditures have been subtracted. Free cash flow is the cash remaining after expenses have been paid, including operating expenses and large purchases called capital expenditures, which is the purchase of assets like equipment or upgrading a manufacturing plant. If a company is generating free cash flow, it’ll have money left over to invest in the future of the business, pay off debt, pay dividends or rewards to shareholders, and issue share buybacks.
Of course, there are many other metrics used in the analysis, including analyzing debt, equity, sales, and revenue growth. After reviewing these metrics, the value investor can decide to purchase shares if the comparative value—the stock’s current price vis-a-vis its company’s intrinsic worth—is attractive enough.