Shares in Serco (LON:SRP) are currently trading at 172.5p, but a key question for investors is how much the current economic uncertainty will affect the price.
One way of making that assessment is to look at the profile of the stock to see where its strengths are. The encouraging news is that Serco has at least some of the traits that are often associated with two influential drivers of investment returns: high quality and a relatively cheap valuation.
To understand where they show up, here's a closer look:
Quality at a reasonable price
Good quality stocks are loved by the market because they're more likely to be solid, dependable businesses. Profitability is important, but so is the firm's financial strength. A track record of improving finances is essential.
One of the quality metrics for Serco is that it passes 8 of the 9 financial tests in the Piotroski F-Score. The F-Score is a world-class accounting-based checklist for finding stocks with an improving financial health trend. A good F-Score suggests that the company has strong signs of quality.
While quality is important, no-one wants to overpay for a stock, so an appealing valuation is vital too. With a weaker economy, earnings forecasts are unclear right across the market. But there are some valuation measures that can help, and one of them is the Earnings Yield.
Earnings Yield compares a company's profit with its market valuation (worked out by dividing its operating profit by its enterprise value). It gives you a total value of the stock (including its cash and debt), which makes it easier to compare different stocks. As a percentage, the higher the Earnings Yield, the better value the share.
A rule of thumb for a reasonable Earnings Yield might be 5%, and the Earnings Yield for Serco is currently 8.05%.
In summary, good quality and relatively cheap valuations are pointers to those stocks that are some of the most appealing to contrarian value investors. While no stock is immune from a sudden setback, focusing on quality and value is what some of the world's best investors do. Once the market recognises that these quality firms are on sale, those prices often rebound.
What does this mean for potential investors?
Finding good quality stocks at cheap prices is a strategy used by some of the world's most successful investors. But be warned: these factors don't guarantee future returns and we've identified some areas of concern with Serco that you can find out about here.