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Valuation driven investing: Guide to calculating investment opportunities

Valuation investment
Key takeaways
Structured CPD
1

Read our guide and take our online test and receive 45 minutes of structured CPD.

Valuation investing
2

Find out how to value stocks like our investment teams and use financial metrics.

Financial metrics
3

Learn about dividend yields, P/E ratios, P/B ratios, ROE and discounted cash flows.

Valuing investments: How to know if a stock is undervalued?

Our investment teams find value in the market by identifying stocks whose value isn’t reflected in the current share price. They then hold on to them until the broader market recognises what they’re worth. 

Analysing financial metrics helps our investment teams find stocks which are undervalued throughout the world.
 

How do investment teams find value?

To help you understand how our investment teams find value, we have come up with a guide that teaches you some of the financial metrics they use to help them pick stocks in their portfolios. Take our test at the end to receive 45 minutes of structured CPD.   

Here, you’ll find out how and why stocks come to be undervalued, how to recognise them and how this investment style could help drive positive outcomes for a portfolio.

In this guide, we also look at the financial metrics and ratios used to determine if a company’s valuation makes a good investment.

Step-by-step we break down how to calculate price-to-earnings ratios (P/E ratio), price-to-book ratios (P/B ratios), return-on-equity (ROE), discounted cash flows (DCF) and dividend yields. We provide you with the formulas so you can calculate them yourself.

By using fictitious companies as examples, you’ll learn how to interpret these financial metrics. Discover which of our apple tree firms has a good P/E ratio or find out what real estate company has a better P/B ratio.  

But valuation driven investing is not without caveats and results need to be considered in the context of the company and the sector. To get the best investment results they should not be used just in isolation, instead a thorough stock analysis understanding using various metrics is needed.
 

Our approach to valuation investing

We offer investment opportunities in both the active and the passive space that make use of financial metrics and ratios to calculate a stock’s value.

In our RAFI ETF range, fundamental measures such as sales, cash flow, dividends and book value are used to determine a stock’s index weight.

The range uses methodology developed by Research Affiliates that assigns weights based on the economic size of a company. On the active side, price-to-earnings ratios, price-to-book ratios, return-on-equity and discounted cash flows are used to identify stocks on low valuations.

This guide looks at these metrics, so you can discover how to do the calculations and understand if a company’s valuation makes a good investment.

FAQs

The price-to-earnings (P/E ratio) helps an investor understand how much a company is worth. The metric reflects a company’s earnings potential. It’s used to determine if a stock is undervalued or overvalued compared to others in the industry. The formula can also be applied to benchmark indexes like the S&P 500. In general, the higher the ratio, the more expensive a stock is relative to its earnings. The lower the ratio, the less expensive the stock. 

Investors use the price-to-book ratio (P/B ratio) to determine whether a company’s stock price is higher or lower than it should be. The P/B ratio is how much an investor is willing to pay relative to its book value.

The book value is defined as the net value of a company’s assets. In other words, the amount shareholders would receive if a company liquidated all its assets and paid off all its debts. It only includes tangible assets such as cash, inventory, machinery and buildings.

If this value is positive the company has more assets than liabilities, if it’s negative it has more liabilities than assets. P/B ratios are useful to compare the valuations of capital intensive companies such as automotive, manufacturers and real estate firms. It’s not so useful for technology companies whose business models are based on intangible assets such as software or trademarks.

Return-on-equity (ROE) examines how well a firm can generate profits from a company’s shareholder investments.

For investors it is a good gauge of how a company is using shareholder money to grow the company and fund operations compared to its peers. Essentially it measures how effective it is at generating net income – the amount a business makes after deducting expenses. 

The discounted cash flow (DCF) valuation metric is used to determine the present value of a company from its future expected cash flows.

It’s based on the premise that the value of future earnings is worth less today than it will be in the future. There is always a risk, however, that the future earnings may not be worth as much as they are today.

Inflation, for example, can erode the value of money over time. In three years from now, £1,000 is unlikely to be worth what it is today.

The valuation gives the investor an estimate of what they would receive from an investment, adjusted for the time value of money. This assumes money today is worth more than it is tomorrow because it can be invested. 

The dividend yield is a financial ratio and is expressed as the percentage of the current share price you get in dividends each year.

The ratio enables investors to compare stocks based on their dividends. It allows investors to see which company has the highest dividend, so you can decide if this return meets your income needs

Investment risks

  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information

  • This marketing communication is exclusively for use by Professional Clients in the UK. It is not intended for and should not be distributed to, or relied upon, by the public.

    This is marketing material and not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.

    Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.

    Issued by Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.