Methodology Behind Sprout Undervalued Stocks Index

Value Investing-Based Philosophy

“Price is what you pay, and value is what you get”, said Warren Buffett. Sprout Stocks follows the same value investing strategies and seeks to help investors pay relatively low price for relatively high value (click here to learn more about value investing).

To make the idea simple. For example, you shop for milk at two different stores. At one store, a gallon of milk is sold at $2; while at another store, one gallon of milk with the same brand and quality is sold at $1. What is your choice? Given the same quality, every single rational buyer will take the latter deal, either buying one gallon of milk for $1 or two gallons for $2.

In equity investing, one popular measurement for stock value is price/earning (PE) ratio. PE ratio tells us how much money we pay for $1 of earning of a company. If stock A has a PE ratio of 10 (meaning we pay $10 for $1 of earning of the company), and stock B has a PE ratio of 20 (we pay $20 for $1 of earning), which stock do you want to buy?

Since $1 of earning from company A is no different from $1 earning from company B, rational investors would buy stock A because $20 can buy $2 of earnings from stock A while the same amount of money can only buy $1 of earning from stock B. It goes without saying that it takes more than just PE ratio to determine if a stock is really undervalued. But this is the idea we follow.

When we buy a stock, we literally buy a part of a business. So, not only we pay for a part of the company’s earnings, but also we get a part of the company’s debt, assets, and future growth too. The goal of our undervalued stock index is to find investing opportunities where we can pay the lowest price for the most “goodies”. Next, I will discuss the factors we take into account in our analysis.

Price is what you pay, and value is what you get.

Warren buffett

Factors Included in Analysis

Our analysis takes into consideration of two major factors: (1) to what extent a stock is undervalued relative to its own intrinsic value, and (2) to what extent a stock is undervalued comparing to other comparable stocks.

1. Intrinsic value of a company

We use classic conservative valuation models such as the Graham formula and the “net-net” valuation to estimate a company’s intrinsic value. These models are chosen because they are proven to be effective and are conservative enough to minimize the likelihood of overestimating a company’s worth.

Then, we calculate the ratio between a company’s market capitalization and its estimated intrinsic value. The lower the ratio is, the more undervalued a stock is relative to its intrinsic value.

2. Relative Value Comparison in the Market

If the first factor is like we evaluating the price and value of a gallon of milk, relative value comparison is like we comparing prices of milk among different stores. In our analysis, we take into account a company’s values, profitability, fundamental financial health, and return to investors.

For relative valuation, we compare among stocks on ratios such as enterprise value to Ebitda, enterprise value to revenue, price to book, and trailing price earnings. We are also interested in the composition of shareholders. Generally, companies that have many institutional investors tend to attract much attention in the market and thus are less likely to be undervalued.

On profitability, stocks are evaluated based on their profit margins, return on asset, return on equity, and earnings growth rate in the past five years (it’s not perfect but we prefer mature companies that have good track of records). Regarding financial health, we like companies with low debt ratios because they are more likely to survive in the changeable economic environment. Lastly, everything being equal, we prefer companies that pay dividends and we equally care about the growth of dividends. So, we compare stocks’ dividend yields and payout ratios.

Machine Learning-Driven Analysis

With all the information about aforementioned factors, the last task is to figure out how hundreds of stocks with different combinations of financial data can be comprehensively analyzed.

To solve this problem, we apply a custom machine learning algorithm to generate the statistically best way to rank all stocks. Since different sectors have different business features, stocks in different sectors cannot be directly compared. So, comparison is only meaningful when conducted among stocks in the same sector, industry, or subindustry.

Limitation

Any analysis is only as good as the data collected. Unfortunately, despite modern technology, not all information about all stocks is available to us. Stocks that do not have complete information are excluded from analysis.

Additionally, ideally, stocks to be compared need to have data for the same time period. In reality, however, companies follow different schedules to publish their financial reports. So, readers can find the time of data on which our analysis is based.

Caveat

The Sprout Undervalued Stocks is a stock screener that relies its analysis on what has happened (we try to limit subjective estimation as much as possible about the future). It is designed to help investors efficiently identify potential investing opportunities but it cannot entirely replace your own due diligence about your investment.


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