Here's the formula for spotting genuinely undervalued companies, claims this investment house

MW Here's the formula for spotting genuinely undervalued companies, claims this investment house

The growth stock vs. value stock dichotomy doesn't make sense, says ValuAnalysis

For most of 2020, investors poured money into names like online retailer Amazon $(AMZN)$, electric-car maker Tesla $(TSLA)$, and e-commerce platform Shopify (SHOP.T)-- "growth" stocks that kept indexes afloat in a turbulent year that hammered share prices across the board.

But when news broke in early November 2020 that drug company Pfizer $(PFE)$ and its partner BioNTech $(BNTX)$ had developed an effective vaccine against COVID-19, something profound happened in financial markets.

Investors rotated out of these investments in favor of "value" stocks hammered by the COVID-19 pandemic, like airlines.

This rotation was based on an essential concept in investing: There are some stocks that are clearly undervalued based on standard metrics.

And it is completely flawed, according to research from ValuAnalysis, a London-based fund manager and equity investment boutique, which specializes in valuation.

The apparent difference between growth stocks and value stocks is that the former is overvalued based on fundamental metrics while the latter is undervalued.

"Everyone knows that this thing doesn't make any sense because growth is not the opposite of value," Pascal Costantini, who led the research at ValuAnalysis, tells MarketWatch.

"It should be high-growth and low-growth, and I can imagine that, somewhere in an office, some guy said 'well this is not catchy enough, so how about growth and value?'"

Analysts and investors use metrics like the price-to-earnings ratio, or price multiple, to value stocks. ValuAnalysis uses price as a multiple of normalized net free cash flow as its benchmark, and identifies the imaginary dividing line between value and growth stocks at 35x, which is the market median.

The value vs. growth divide would suggest that a company trading at a 17x earnings multiple is undervalued. In reality, ValuAnalysis says it is likely a company that won't grow.

In reality, a stock's value is based on the company's ability to grow free cash flow in an environment where the cost of capital is 5% to 6%. So if a company isn't outpacing that by improving revenue and margins, the multiple won't increase and the stock price is unlikely to rise.

Stocks that are actually undervalued will trade between 25x and 35x free cash flow, Costantini says, outpacing the cost of capital but not breaking past the market median.

To have potential, a company's accumulation of assets or revenue growth must outpace increases in global gross domestic product, and ideally show signs of accelerating. There must also be an increase in operational leverage through revenue or margins. A decrease in the risk premium, such as through advances in controlling carbon emissions, helps.