August 23, 2019

How to Pick Value Stocks

Picking stocks isn't simply a matter of choosing a few companies you like, then executing some trades—just because a company makes stellar products doesn't guarantee it will be a good investment.

If you want to find quality stocks that have the potential to go the distance, it's far better to dig into their financials. How are profit margins? Is the company overleveraged? What about cash flow?

The fundamental goal here is to identify companies that might be undervalued in the marketplace, also known as value stocks. Here are our four favorite metrics for evaluating the financial health of such stocks.

1. Price-to-earnings ratio

Looking at a company's price-to-earnings (P/E) ratio—that is, its current stock price relative to its earnings per share—is useful for determining its intrinsic worth relative to its market value. A lower P/E ratio, for example, suggests the stock may be underpriced and could have room to rally.

Some investors look at a P/E ratio based on expected earnings; however, that introduces another layer of guesswork. We suggest sticking with historical earnings and looking at profits over the past four quarters. And since these ratios tend to vary between sectors, make sure you're comparing the P/E ratios for companies within the same sector.

To view a company's P/E ratio over time, log in to the Research tab, enter its ticker symbol, click the Charts tab and then select P/E Ratio from the Indicators dropdown.

2. Return on equity

After gauging a company's valuation, you'll want to know about the quality of its earnings. Does the company have the financial strength to maintain its profits or, ideally, to grow them? One way to assess this is by looking at its return on equity (ROE), or how efficiently the company uses its capital. One formula for determining this is:

net income ÷ (assets – liabilities)

A higher percentage is better, but, as with P/E ratio, a company's ROE should be assessed relative to its peer group.

Be aware that a sudden jump in ROE may be due to an increase in a company's debt—not an improvement in its profitability. So always check to see whether a company's debt levels have changed significantly.

To find a company's ROE, log in to the Research tab, enter its ticker symbol and then click the Ratios tab.

3. Volatility

Swings in the price of a stock can be an indication that investors are uncertain about its earnings. What is the degree to which the daily share price fluctuates relative to its industry peers? Generally speaking, you want a stock to have lower-than-average volatility, as it may signal steadier earnings. Unfortunately, such analyses can be difficult for individual investors to perform, in which case consulting volatility forecasts from industry experts can help.

Schwab Equity Ratings® include a Price Volatility Outlook for all rated stocks. To screen for stocks by their volatility outlook, log in to your account, click Analyst Ratings, select SER Volatility Outlook, and then choose Low, Medium, and/or High.

4. Momentum

Increasing investor interest is a positive sign, all else being equal. If, over the past six months, a stock's price has broken above the range it had been trading within for an extended period, the stock could have momentum and may continue to climb. That said, positive momentum is more like extra credit and shouldn't trump other metrics such as valuation.

To view a company's momentum over time, log in to the Research tab, enter its ticker symbol, click the Charts tab and then select Momentum from the Indicators dropdown.

Proceed with caution

These four metrics are a start, but successfully picking individual value stocks is difficult, mostly due to the amount of research and time it takes. As a result, even the most talented amateurs might want to limit their investment in individual equities to 5% to 10% of their nonretirement portfolio.

Do it yourself (with help)

Schwab Equity Ratings is a system we developed at the Schwab Center for Financial Research that evaluates some 3,000 U.S.-traded stocks using a wide variety of financial metrics. We assign each stock a letter grade from A through F, depending on how likely we think it is to outperform or underperform the market over the next 12 months. Stocks that earn an A rating, for example, are expected to strongly outperform the market, while those that earn an F are expected to strongly underperform.

Just how well does the ratings system work? If you look back at nearly 17 years of data, top-rated (A) stocks outperformed middle-rated (C) stocks by an average of 3.47 percentage points, while the lowest-rated (F) stocks underperformed the middle group by an average of 8.58 percentage points.*

If you have your own ideas for how to pick stocks but want to narrow the pool you select from, screening for A or B stocks may be a good place to start.

To find the Schwab Equity Rating for a prospective stock investment, log in to the Research tab, enter its ticker symbol and then click on its Schwab Equity Rating letter grade to view the full report.

*Source: Schwab Equity Ratings. Data from 05/06/2002 through 04/23/2019.