All traders want to buy undervalued stocks. Who doesn’t want to buy an undervalued stock and just watch it go up? Traders find value using either technicals or fundamentals. We’re going to be focused on the basics here and analyze how to find undervalued stocks using fundamentals. Although we’re primarily focused on technicals and catalyst events, we don’t completely ignore the fundamentals. Basically, the more you know about a stock, the better.
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Now, finding undervalued stocks is easier than you think. There are plenty of free tools out there for you to use. We’re going to focus on the price-to-earnings ratio (P/E) and how to see whether a company could be undervalued.
Undervalued Stocks: P/E Explained
The price-to-earnings ratio (P/E) is one of the most widely-used fundamental analysis tools out there. You’ve probably heard the talking heads discuss P/E. You may have heard Jim Cramer say, “This stock is trading at 10 times its earnings.” When someone says something like that, they’re quoting the stock’s P/E.
When a stock’s P/E is below that of its industry, it means the stock could be potentially “cheap.” Just because a stock’s P/E ratio is below its industry, it doesn’t mean the stock is undervalued. It could mean that the market is pricing in other factors. Additionally, market participants might think the company could potentially be headed for financial trouble. Stocks that don’t rebound after a big selloff do so for a reason. Therefore, if you find a stock with a low P/E ratio, do some more digging.
Traders and investors looking for undervalued stocks tend to use the P/E as the first filter layer.
On the flip side, if a stock has a P/E ratio greater than that of its industry, it doesn’t mean the stock is necessarily overvalued. Maybe the market is pricing in future earnings and believe the stock could run higher due to its earnings projections.
To calculate a stock’s P/E, you simply divide the stock’s current share price by its most recent earnings per share (EPS) over the past 12 months. For example, if a stock is trading at $20 per share and its trailing 12-month EPS was $2, then it has a P/E of 10.
One thing to keep in mind when comparing P/E ratios is that you need to compare similar companies. You can’t compare the P/E ratio of a homebuilder to a tech stock.
Undervalued Stocks: Comparing P/E Ratios
Again, the P/E ratio could help you find undervalued stocks, but it’s not the be-all and end-all for fundamental tools.
Morningstar allows you to easily compare P/E ratios. For example, here’s a look at L Brands Inc (LB).
When comparing the current price/earnings ratio to the index, LB would be considered one of the many undervalued stocks. However, this doesn’t mean you should go out and buy shares of LB right away.
The next thing you want to do is look at the chart and see if there were any events to cause this inefficiency.
Well, if you look at LB on the daily chart, you’ll notice the stock had two gap downs. This was due to a pre-announcement and earnings. Basically, the company indicated there were tough times ahead. The market priced that in, but LB actually caught a bounce shortly after selling off. The stock is still considered undervalued, when compared to its competitors. However, you would want to wait for a clear entry. You might consider using technical patterns to signal your entry.
Now, if you want to filter for undervalued stocks with low P/E, you could do so using Finviz. Here’s a look at a filter of stocks with a P/E less than 10 and a market capitalization greater than $300M.
Once you’ve found an undervalued stock and conducted your due diligence it’s time to execute. If you’re an advanced trader who knows how to trade options, you might consider using this simple options strategy that could potentially double or triple your money.
The Bottom Line
If you’re looking to find undervalued stocks, the price-to-earnings ratio (P/E) could be a powerful tool. However, there are a few factors to keep in mind. First, you should only compare a stock’s P/E ratio to its industry or comparable companies. Second, you need to remember that the P/E ratio is not the be-all and end-all of fundamental indicators. You’ll need to look at other fundamental tools or technicals. When you combine different types of analysis, it could increase the probability of a trade working out. That said, you could use the P/E ratio as your first layer of filter, but don’t let it be the only bullet in your arsenal.