Academic journal article International Review of Management and Business Research

A Study of Value Investing: Profit, Dividend, and Free Cash Flow

Academic journal article International Review of Management and Business Research

A Study of Value Investing: Profit, Dividend, and Free Cash Flow

Article excerpt

Introduction

Investment and financial management have received increased attention in recent years, and stocks have been considered to be a simple effective investment instrument. However, the number of investors who experience losses in the stock market exceeds the number of those who gained profits. Events such as the financial crisis in 2008 and the recent Eurozone crisis have negatively influenced the stock market, causing investors' assets to decline considerably, and engendering uncertainty and unease among investors in the capital market. Therefore, this study intends to explore how investors should invest in stocks to earn profits and whether a simple investment strategy for conducting safe and efficient investment is available.

Since Benjamin Graham first proposed value investing, numerous scholars have successively conducted studies on this topic. The majority of these studies have analyzed price-earnings (P-E) ratios, price-to-book (P-B) ratios, and price-to-sales (P-S) ratios. Lakonishock, Shleifre, and Vishny (1994) studied the U.S. stock market by observing the P-E ratio, P-B ratio, price-cash-flow (P-CF) ratio, and average-sales growth rate (GS) over 5 years. O'Shaughnessy (1996) analyzed the P-E, P-B, P-S, and P-CF ratios and considered capital stocks to investigate the U.S. stock market. In addition to using similar indicators, Bauman, Conover, and Miller (1998) employed the dividend rate and the expected-earnings growth rate to distinguish growth and value stocks. Chen (2004) examined the interactions among various conditions, months, scales, and monetary environments in the stock market in Taiwan to investigate whether the Taiwanese stock market contained value investing. Yu (2011) examined the stock market in Taiwan by examining the P-E ratio, bargaining counters of a juristic person, returns on equity, dividend yields, gross profit margins, and revenue growth. Domestic and foreign studies have revealed that the return on value investing portfolios was superior to the performance of the Taiwan Capitalization Weighted Stock Index (TAIEX) in the same period. However, value investing may be overly complex for general investors who do not possess a relevant academic background, compared with investing in growth stocks or TAIEX. Therefore, the objective of this study was to determine a simple method for value investing.

The use of the P-E ratio in the aforementioned studies may be problematic. A company, the profit of which is declining, may exhibit a low P-E ratio because of the previous high profit and the decrease in stock prices. Therefore, the stocks of this company may be mistaken for value stocks. This is a frequent problem encountered when using the P-E ratio and, thus, this study did not use the P-E ratio as a variable.

The P-B ratio, which has been frequently employed in previous studies, is also an indicator that may produce distorted result. In the Taiwanese stock market, a company that acquires substantial profits typically exhibits a high P-B ratio; by contrast, the stock prices of a company with low gains is lower than the book value of the stocks. Currently, although the value of TAIEX is above 9000, the P-B ratio of more than 30 Anns is lower than 1, including Anns with losses or low profits such as Genius and Altek. Typically, Anns that have consistently gained high profits rarely exhibit stock prices lower than the book value of the stocks. Therefore, this study did not use the P-B ratio as a variable.

Buffett's philosophy of value investing emphasizes purchasing stocks of stable companies and retaining the stocks for a long period; the quality of a company is evaluated based on whether it can earn cash. Additionally, the company should be able to gain profits under any conditions. Based on these principles, this study established the profit, dividend, and free cash flow (PDF) model, which can be used to select companies based on the following three criteria:

(a) Profitability: A company's net profit after tax over the 10 consecutive years in the research period is positive. …

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