All traders want to buy undervalued stocks. Who doesn’t want to buy an undervalued stock and just watch it go up? Traders find the value of stocks using technical analysis, fundamental analysis, or a combination of both techniques. We’re going to be focused on the basics here and look at how to identify undervalued stocks using fundamentals. Basically, the more you know about a stock, the better positioned you are to make a smart trade.
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Now, finding undervalued stocks is easier than you think, especially if you take advantage of the multitude of free resources available. We’re going to focus on using the price-to-earnings ratio (P/E) to determine whether a company could be undervalued.
What Are Undervalued Stocks?
Any stock with a current price well below its actual value can be considered undervalued and has the potential to provide significant profit if you play your cards right. The intrinsic value of a stock can be determined based on price to earnings ratio as described in this article, but some investors determine this value based on other metrics such as price to cash flow, sales, or book value or the stock’s dividend yield.
Characteristics of the company itself can also be useful in predicting undervalued stocks. For example, you should suspect that a stock is undervalued when a company has a stable product that is not likely to become obsolete, has an outstanding credit rating or no debt, remained stable or increased in value during the most recent recession, and/or is currently on the market for a price significantly lower than the value of its assets.
Using P/E Ratio To Find Undervalued Stocks
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 undervalued. Traders and investors looking for undervalued stocks tend to use the P/E as the first filter layer. However, 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 be headed for financial trouble. Stocks that don’t rebound after a big selloff fail to do so for a reason. Therefore, if you find a stock with a low P/E ratio, do some more digging.
On the flip side, if a stock has a P/E ratio greater than that the average for its industry, it doesn’t mean the stock is necessarily overvalued. Maybe the market is pricing in future earnings and believes the stock could run higher due to its earnings projections.
To calculate a stock’s P/E, 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 home builder to that of a tech stock.
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.
If you look at LB on the daily chart, you’ll notice the stock had two gap downs, respectively caused by a pre-announcement and earnings. Basically, the company indicated that it’s facing 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 the value of similar firms. However, you would want to wait for a clear entry, which is where the chart patterns of technical analysis may come into play when you use these techniques to look for a signal.
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 a 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) is often a powerful tool. However, you must keep a few factors in mind when taking advantage of this technique. 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, you dramatically increase the probability of a successful trade. For best results, use the P/E ratio as your first layer of filter to find an undervalued stock, but don’t let it be the only bullet in your arsenal.