Distinguishing "Value Stocks" From "Value Traps"
Investors often underperform their expected returns. In particular, this is common among so called "value investors". Whatever method they used to determine the value ( Relative valuation, discounted-cash flow, p/e, pe/g.pb, etc) may prove worthless if the company does conduct efficicent operations. There are two key measures which any "value investor" should employ against those in the industry and the market as a whole.
1) Earnings Yield- Many people familiar with this but don't employ it correctly. The quality of earnings is the first step, in other words remove any one time items and either remove reoccuring income from other sources or normalize it. In essence this will reveal the quality of earninigs from operations which are more likely to exist in the future. The adjustment is determining the earninigs yield by dividing enterprise value to eps (EV/EPS). EV = Current share price * shares outstanding - cash and marketable securities + debt. After you compute this ratio you merely take the reciprocal .. 1/(EV/EPS). A quick example: Company A earned 40 million from operations. It has 120 million in debt and 15million in cash. They have 75 million shares oustanding and the current price is 4$/share.EV=4*75million+120million-15million = 405 million. Earnings Yield: 405/40= 9.87%Using the reciprical of the Pe would give an artificially high EY = 300/40= 13.33%
2) Measuring the efficiency of a company's operation: This is done by taking Pre-tax Return on capital. There multiple firms who look like a deal but have low return on capital. This is very easy to calculate: EBT/Net PPE.
Conlcusion: When comparing what your determine "values" add the earnings yield and return on capital toghether. Do this for other players in the industry or other equities. Obviously there are exceptions. But you can negate some of this by using forward measures of these going out as long as you think you can accurately project. Joel Greenblatt wrote about this is a very small book with a bad title but it is very telling.