5 Crucial Things for Value Investors to Consider When Evaluating Stocks

5 Crucial Things for Value Investors to Consider When Evaluating Stocks

Value investors use specific metrics to find great deals. Some popular ones they use include the price-to-sales ratio , the price-to-earnings ratio , and the price-to-book ratio . And these tools certainly have their place. But they’re not everything investors need to find great deals in the market.

In this video from Motley Fool Live , recorded on Sept. 9 , value investor at heart and Motley Fool contributor Matthew Frankel talks with fellow contributor Jon Quast about five other things value investors should keep in mind when buying stocks. Matt and Jon think investors should consider a company’s sales growth, gross margin, margin expansion, total addressable market, and net dollar-based retention rate. 10 stocks that could be the biggest winners of the stock market crash

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Jon Quast: What Matt just talked about was these valuation metrics, and I want to underscore: When we talk about valuation with stocks, we are not talking about the price per share. It’s really irrelevant in many ways. I’m going to liken it to the grocery store. You pick up a pack of chicken. It says 10 bucks on the package and it’s five pounds. Is that more expensive than a $8 bag of chicken that only has two pounds? No, the price per pound is different in those two situations. While you might spend less on an $8 package of chicken, if it’s $4 a pound, that’s more expensive than the $10 package that is $2 a pound. That’s what these valuation metrics are doing. They’re measuring, not the stock price, but the valuation based on the sales, the earnings, things like that.

But most of those are backwards looking, so they’re looking back over the last 12 months. And at most, most of them are looking forward over the next year. But as investors, we’re thinking about something way bigger and way more long term than what has happened over the last 12 months or what might happen over the next 12 months. We’re really thinking more long term, and that’s why we need to use valuation metrics, yes, but in inappropriate context.

Some of the things that we look at here are sales growth. Why might this matter? A company might look expensive on a price-to-sales valuation. But what if they’re doubling their sales in each of the next three years. Well, all of a sudden — and that’s the time frame that we’re looking at as investors, three to five years. What if they’re going to grow, doubling each year. Well, all of a sudden their sales are going to be much bigger in three to five years than they are right now. The valuation as we project out, maybe it’s not so expensive once we add in that context.

Gross margin and margin expansion. This is another important thing for investors to incorporate into their valuation understanding. What is gross margin? This is how much it cost a company for its revenue. If it had to spend $5 for a product and is able to sell that product for $10, their gross margin is 50%. It cost them $5, they sold it for $10. Gross margin is a very important thing to consider because this shows you your profit potential. Maybe the company is spending most of its gross profits on building a new warehouse or just growing the business, spending a ton on sales and marketing and it will show that they are unprofitable. But if you look at the gross margin, you see that the company is not structurally unprofitable. This actually is a very good business, but they’re spending to continue to grow the top line.

One that comes to mind here, as we talk about gross margin and how this might play in, s oftware-as-a-service companies . Many times these companies have very high gross margins, sometimes even 80%, 90%. Why? They built their software, they have that cost of building it, but they can sell it many, many times, and so their cost is fixed right there […]

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