Value investing

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9. Earnings - an example

Simon Flather, editor of a newsletter which specialises in spotting undervalued stocks, gives the following example of an undervalued stock situation:

"In February 1999 shares in telecoms company IMS Group stood at just 139p. We concluded that these shares were undervalued because at the time the prospective P/E for the year ending in October 1999 was under twelve. For a company which operated in rapidly growing markets we felt that this was much too cheap and our buy recommendation was vindicated when the shares rose during the year to a peak of 960p. Now many readers would probably say that IMS Group would qualify as a growth stock and not a value stock and yet because the P/E ratio was so low we would counter that it also qualified as a value stock."

Note the reference to 'prospective P/E'. This simply means that the P/E is calculated on prospective 'leading' earnings rather than actual 'trailing' earnings. Because it is prospective, it is inherently less reliable.

Simon continues:

"What drew our attention to IMS Group in the first instance was the release of its annual results for the year to October 1998. Despite incurring some re-organisation costs relating to acquisitions the group was still able to report an increase of 8% in pre-tax profits. However, what really made us look at the company in more detail was the fact that significant growth in profits was likely during the current year and yet this had not been reflected in the share price which stood at around the 1997 flotation price of 135p. So, although the company had made significant progress since flotation both in terms of developing its business and in increasing profits and earnings per share this fact had not been recognised by the stock market. As a result the shares were languishing on a very low P/E which represented outstanding value."

Further tips:

• Averaging over Time
  To iron out short-term distortions, calculate ratios over a number of years. This will give you a truer picture of the company's performance.
• Ignore One-Offs
  For example, a large and unforeseeable bad debt, or a natural disaster, or a large one-off profit from the sale of a piece of land. They don't give a true picture of the company's ongoing performance.
• P/Es are no use for companies with erratic earnings - like insurance companies or commodity traders - or other specialist companies like investment trusts of property companies where investors are mainly concerned with the value of the assets.
• Watch out for creative accounting, especially companies fudging their earnings figures. A reliable measure of real earnings is dividends + the increase in net assets per share.

1. What is value investing? 2. Ben Graham 3. Does value investing suit you? 4. Back in fashion 5. Undervalued assets - introduction 6. Undervalued assets - property companies 7. Debt 8. Earnings 9. Earnings - an example 10. Dividends 11. Ratio of market capitalisation to sales 12. Warren Buffett's principles 13. Why do stocks become undervalued/overvalued? 14. Conclusion

• Value Growth Investing