Develop a better understanding of stock valuation metrics and how to locate potentially undervalued investment opportunities.
Are you an investor who likes shopping in the stock market’s bargain bin while others chase high-flying headline grabbers for stratospheric prices? That’s a popular strategy, but price tags might not tell the full story. Assessing value versus growth stocks, as with almost anything you buy, cheap isn’t necessarily better if you want the best value.
“One of the key things that allures people to value investing is the hope that they might be able to buy something at a price that is cheaper than the actual worth of what they’re buying,” says Michael Fairbourn, education coach, TD Ameritrade.
The quick and dirty way to determine a stock’s value is its price-to-earnings or P/E ratio. To find it, simply divide a stock’s current price by its earnings per share. For instance, if a stock trades for $100 a share, and last year the underlying company had earnings per share of $4, the P/E is 25.
Seems simple enough, right? Maybe not. Like an unscrupulous vendor, P/E can sometimes lead you in the wrong direction, which means finding the best value stocks might not be as elementary as getting the same pair of shoes for $5 less on another website.
Imagine two stocks in the same industry; we’ll call them stock A and stock B. (It’s helpful to compare stocks in the same industry, because similar companies are more likely to be influenced by similar fundamental factors.) Suppose stock A has a P/E of 10, and stock B has a P/E of 15.
At first glance, stock A might seem like a better value investing candidate than stock B, because investors can buy it for a lower price compared to earnings than its competitor. But not so fast: P/E doesn’t take other key factors into account that help determine stock price, including growth. Once you throw growth in, it becomes a different picture.
If stock B (P/E of 15) is expected to be growing by 18% and stock A (P/E of 10) is expected to be growing just 10%, many investors would probably rather pay 15 times earnings for 18% growth than 10 times earnings for 10% growth. In other words, it’s not necessarily a good idea to invest based on P/E alone, but rather use it as one data point in your investment research.
“When you’re trying to determine value, it helps to do a little trend analysis in terms of the actual financials,” Fairbourn says. “How is the company developing? Is it undervalued because projected growth has been getting stronger over time?”
So how does the average investor find this information? That’s when it helps to know the price/earnings-to-growth ratio, or PEG.
The PEG tells a more complete story than P/E alone because it takes growth into account.
The lower the PEG, the more undervalued the stock, based on forecasted growth.
Again, let’s look at two hypothetical stocks in the same industry:
The conclusion? Stock B has a lower PEG than stock A, meaning that by this measure, it’s actually the better value investing candidate. Generally, a PEG below 1 means the stock could be considered undervalued (by this metric).
To locate a stock’s PEG on TD Ameritrade, type in the symbol and click on the Valuation tab, as shown in figure 1.
“To get PEG, all we’re doing is taking P/E and dividing by the next year’s projected growth,” Fairbourn says. “What’s neat about it is if the PEG is less than one, it means what you’re paying in terms of P/E right now is cheaper than the projected growth in the future. Earnings are projected to go up in the next year, but now the stock is cheaper than that future earnings number. So the upshot is there’s a likelihood that the stock might rise in price because earnings are increasing.”
Knowing PEG can also potentially help protect you from buying a stock that has a low P/E because it deserves it, which would be the market equivalent of buying a pair of inexpensive shoes that start to unravel after a few short jogs.
Another helpful valuation tool is price-to-book value, which compares a company’s stock price to the value of the net assets (assets minus liabilities) on its balance sheet. A lower price-to-book value can sometimes indicate that the stock is at a reasonable valuation. You can find price-to-book value in figure 1.
Some investors value a stock by how much cash flow the company generates. They may monitor mergers and acquisitions in the company’s industry to see the type of valuations given to the company’s competitors.
Knowing all this about value, it might become clear that low P/E isn’t where it’s all at. In fact, sometimes a stock with a very high P/E, even at 50, might actually be worth a look.
“A 50 P/E stock could be a value stock if you see high enough growth and you’re confident enough in the company,” Fairbourn says. “People might be paying a 50 P/E, but if earnings are expected to be growing 25%, investors might see the stock as cheap relative to next year’s value. Some people think value is bargain basement, but don’t factor in PEG and growth. Some investors like stocks that will be value stocks in the future based on today’s price.”
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