Value investors like solid stocks selling at low prices, so we begin by looking for stocks with low price-to-book-value ratios (P/B). This number compares the market value of the company to how much money you could raise by selling off all the company’s assets (at their balance-sheet prices) and paying off all the firm’s debts. You can think of a low P/B ratio as assurance that you’re not paying a lot more for a stock than its ingredients are probably worth. To get top value marks in our rating system, a stock has to possess a low price-to-book-value ratio compared to the market and also compared to its peers within the same industry.
Other factors matter too, of course. Good companies produce profits so we award higher scores to firms that have positive price-to-earnings ratios over the past year (this backward-looking figure is known as the trailing P/E ratio). We also reward a company if industry analysts expect it to have a positive P/E over the next year (this number is known as the forward P/E ratio).
Because we like to have a little spending money in our wallets, we award extra marks to dividend paying stocks. And to ensure a company won’t be sunk by excessive debt, we penalize spendthrift companies living on credit. We award the best grades to firms with low leverage ratios (defined as the ratio of assets to stockholder’s equity) compared to their peers. Finally, we combine all these factors into a single value grade. Only 50 out of 500 stocks got an A this summer.
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