When considering a quick valuation method, most people will turn to the price to earnings ratio or the price to book ratio. However, earnings can be manipulated easily and book value is far from the best true measure of value. Instead, I believe that comparing the price to the free cash flow (what's left over for shareholders after normal expenses used to keep the business running) is just as simple to calculate, but much more useful in identifying cheap stocks.
There was an intriguing back test done last year by Peter George Psaras to see if stocks with low price to free cash flow ratios truly outperformed the overall market. He did this by creating a hypothetical portfolio in which at the beginning of each year from 1950 to 2007, he "purchased" an equal weighting of the companies in the Dow Jones Industrial Average that had a price to free cash flow ratio of under 15, and then sold them at the end of the year. The results were startling. This portfolio outperformed the Dow for 53 of 58 years and had an average gain of 23% versus 8% for the Dow. A $10,000 investment in this hypothetical portfolio in 1950 would have been worth $974,617,645 by 2007, or 1434 times more than what the Dow would have returned.
Not only does this show the power of this particular tool, but it is a testament to simplicity when choosing an investment philosophy. It would take no time at all to manage this portfolio, yet it has yielded results that professional money managers would kill for.
Subscribe to:
Post Comments (Atom)
No comments:
Post a Comment