Fans of Warren Buffett are most likely also fans of value investing. The concept is extremely popular due to its intuitive nature. First, you find a good company whose share price is below what the company is really worth. You buy the share at a low price, wait for the share price to reflect the company’s true worth and make money in the process. The trouble is, how are we supposed to know what a company is really worth?
Active managers pour over results, attend presentations, speak to the company’s management and other analysts and analyse the industry and geographies in which companies operate to try to determine a company’s true value. Only after extensive research do they make a call about whether a company is undervalued. Those of us who only have a few hours to think about our investments are unlikely to do a better job discovering a company’s true value.
As of this week, however, index investors have an opportunity to add a value slant to an ETF portfolio without all the legwork. The Absa NewFunds Value ETF (NFEVAL) methodology is designed to find and invest in companies that are trading below their true value. They use two metrics to determine a company’s true value, namely the P/E ratio and the P/B ratio. Don’t worry we explain both below.
The price-to-earnings ratio
TLDR: Low is good
The first metric to determine value is the price-to-earnings (P/E) ratio. This term describes how many rands you are willing to invest for each one rand you can earn. A lower P/E ratio means you have to pay less for each R1 of earnings.
Another way to think of it is how many years it would take before one of your shares earns R1 profit. For example, if a company’s P/E ratio is 20, you pay R20 for each R1 you’ll earn from the company. It would take 20 years before you earn more from the share than you paid for it. For the 20 years before that, each R1 you earned went towards the R20 you invested in the company. Only by year 21 are you getting more than you put in. Companies with a low P/E ratio are included in this ETF, because companies that cost very little but earn very much can earn investors more money.
The price-to-book ratio
TLDR: Low is good
The second metric the ETF uses to find a value company is the price-to-book (P/B) ratio. This compares the book value of the company to its share price. The book value of a company is how much all of the company’s assets are worth once you’ve subtracted all the liabilities.* If the company were sold today, the price of that company would be based on the book value. The P/B works out what a company’s share price would be based on the book value (by dividing the book value by the amount of shares) and compares that to what the shares actually cost in the market. If the shares cost more than the book value per share, it means investors think the company is worth more than the actual assets it owns. If the shares cost less than the book value per share, it means the company is undervalued.
How the ETF uses these ratios
The NewFunds Value ETF tries to find companies that have both a low P/E and P/B ratio. The thinking is that these companies’ share prices don’t reflect what the companies are actually worth if they had to be sold today. This means investors currently don’t have high hopes for these companies and are therefore unwilling to pay for the shares. For investors in this ETF, that means you need to allow enough time for market sentiment to come around. As different sectors do better or worse, different constituents in the ETF will do better or worse.
It also means that companies that were initially included in the index due to low ratios will fall out of the index when these ratios rise. Those familiar with how ETFs ordinarily work might find this a bit counter-intuitive. Ordinarily, a company only falls out of the ETF when it performs poorly. However, this ETF needs to make space for value buys by kicking out companies that gain momentum. Improved sentiments around each of these companies will most likely see a rise in the P/E and P/B ratios.
* This is also true of your own book value – everything you have minus everything you owe is the book value of your portfolio – also known as your net worth.
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