Long-Term Value Indicators in the Traditional Stock Market

• In 1934, Columbia Business School professors Ben Graham and David Dodd published a textbook called "Security Analysis." Their central theme defined what is commonly referred to as value investing in the stock market. It focuses attention on companies that are undervalued relative to fundamental indicators of a company's worth. Warren Buffett has been the CEO of value investing for the past quarter century. Even if you're not a value investor, it's worth knowing what kind of indicators value investors like to see.

Price-to-Earnings Ratio

• The price-to-earnings or P/E ratio is calculated by dividing the stock price by the earnings per share (EPS). P/E ratios vary between industries. If a company has a higher P/E ratio than most of its competitors, it is probably overvalued. If it has a P/E ratio lower than most of its competitors, it may be undervalued. An undervalued stock is generally a promising sign; however, it cannot be interpreted in a vacuum. In an economic upturn, whether within the industry or in the economy as a whole, a high P/E may not necessarily mean the stock is overvalued. It may be influenced by a strong and rapid growth.

Price-to-Book Ratio

• Book value is the worth of a company if it were liquidated. The price-to-book ratio is calculated by dividing the stock price by the book value per share. If a stock is selling well below its price-to-book ratio, it is undervalued. If it is above the price-to-book ratio, it is thought of as overpriced. As with P/E ratio, the price-to-book ratio should not be viewed in a vacuum. In certain circumstances, especially in a strong and growing industry, stock prices above the price-to-book value may represent more of a lagging indicator than a predictor of future performance.

Net Working Capital

• Net working capital is perhaps the most important value indicator. Although debt is not necessarily a bad thing in business -- it often is used to finance growth -- a company laden with debt relative to its liquid assets is in a precarious situation. Net working capital is the difference between current assets and all liabilities, including long-term debt and preferred stock. The exclusion of fixed assets allows you to identify companies that could pay off all liabilities quickly and could take advantage of an opportunity on a dime. A stock price below the company's net working capital per share is a strong value signal. This stock is not only selling for less than what it is worth, it is selling for less than what it is worth in only liquid assets.