How To Find Value Stocks Using This Simple Filtering Method

Key Points

• The art of value investing is more accessible than you think; you only need three simple metrics to help you filter out a few select names from thousands of options. 
• Following these case studies, you will be able to spot the trends that make up a good deal and provide you with a repeatable process for finding more of them in the future. 
• The takeaway is this: once you find them, analyst targets provide a sounding board with high upside targets to confirm your thesis.

What is a value stock? What makes it a value stock? What is value? These questions date back before the initial 'Where do we come from?'. Today, you will get a sense of what constitutes investing in valuable, high-quality assets, taking a chunk of brains from Benjamin Graham, Warren Buffett, and other art professors.

There are two definitions of value in their books: the 'fair' market value that most participants are willing to pay and the price most results-oriented money managers and investors want to spend.

Think of it like an iPhone; you know that you should pay somewhere between $1,000 and $1,500 as a 'fair' price. If someone were to offer you one for $5,000, you'd turn them away, and if the next day that same person offered you one for $300, you'd buy as many as you can. 

A Case for Value

Value begins with quality; in business, quality can be defined by qualitative or quantitative analysis. Taking the likes of Shutterstock NYSE: SSTK, you can spot value by finding outliers in both business fundamentals and the numbers.

In a qualitative sense, business quality can be defined as the market penetration or moat that Shutterstock displays. While operating in a highly competitive environment, management makes the right sacrifices to retain a leadership position. 

Contributors to Shutterstock's content base are growing like a hiccup each year, with 2.3 million in total today. The top five contributors represented less than 2% of the full content in 2022, substantially spreading operational risk.

Further, talent retention seems to be a significant focus in the business, as it offers one of the most competitive compensation packages in the space, and with better talent comes better clients. Revenue risk is also thinly spread out across more than 600 thousand customers.

KPIs (key performance indicators) are acronyms that excite any banker; in the case of Shutterstock, you can look at growing subscribers and revenue per download, etc. These metrics jumped by double-digits during the latest quarterly earnings results for the business, connecting those solid fundamental setups to the numbers aspect of things.

With a gross profit margin of over 60%, Shutterstock's financials begin to tell a story of moat-building. A 60% margin speaks to pricing power and the ability to navigate competitive environments more successfully, as finances are flexible for investing in the right places.

Before the COVID-19 pandemic and the heavy digitalization of most of Shutterstock's clients, management was investing capital and receiving roughly 10% returns on average; with today's trends (not expected to slow down any time soon), returns are looking more like 15% and rising.

Why are returns on capital necessary for value? Well, investing in a high-quality business or assets implies that it will provide you with decent returns, and in the case of ROIC (return on invested capital), these are the returns that the business - or stock - spits back at you every time you invest in it.

Closing the loop on this thesis, you can see Shutterstock's earnings per share. The CAGR (compounded average growth rate) is 12% over nine years, reflecting a near mirror image of the ROIC achieved during the same period. The higher and more stable the ROIC, the better your stock will do in the long run.

Other Ingredients

High-quality business models, that generate as high as possible ROIC got it? Now what? Contrary to popular belief, value is what you get, while price is what you pay. Price is a significant factor in making a suitable value investment.

If you look at Academy Sports and Outdoors NASDAQ: ASO, you can work down the checklist again. With a constant gross profit margin of over 30%, this company is a clear outlier in retail stocks.

Building upon this first metric, investors can note that the business has generated an average ROIC of 12-15% over the past five years; let the compound returns begin.

Moving past the quality check, you can now determine if the price is right to get the correct returns. The price to book valuation in Academy Sports currently sits at 1.9x, around the same valuation the company fell to during the peak months of COVID-19.

This makes a lot more sense: a high-achiever business for a discount. Analysts can give you a reasonable-sounding board, though your research is the law of the land here. Analysts have assigned a price target of $69.2 a share, implying a 59% upside from today's prices.

What about Shutterstock? Analysts also see a decently high potential upside of 110%, speaking to the high quality of the business for an insane discount in today's prices.

Starting to see the trends? High margins, high returns on capital, and a reasonable discount to historical prices or other peers. 

One More Rep

The last subject to drill into the method behind the madness, Tapestry NYSE: TPR, comes to test your knowledge. Starting with margins, this business carries a gross margin of over 70%; talk about pricing power!

Returns on capital? Yes, please, this business generates ROIC between 12-15% as well; by now, you should be able to guess what will happen to EPS and the stock price over the long-run. 

Like this deal so far? Good, now you should figure out whether this is a potential buy today or whether you should wait a bit for better prices. On a P/E basis, this stock is trading at a 7.1x multiple, the same as during the financial crisis of 2008.

Analysts are on top of this trend, so they see a net upside of 75.5% from today's prices; thank you very much. When you feel bold enough, return to this simple guide and fish for some of the best deals. 

Good margins, good quality, and returns on capital, with a reasonable discount, your new creed.