Use these 3 metrics to find undervalued stocks | Smart Change: Personal Finance
The ability to find and invest in undervalued stocks is a great ability to be an investor. Big companies can often fly under the radar or be underpriced by the market, and they can be able to identify those companies that can pay off big with returns — just ask Warren Buffett, who has made a fortune to find undervalued companies. of its worth. If you are looking for undervalued companies, using these three metrics will help you.
1. Price to Earnings Ratio (P/E)
There are not too many metrics commonly used to determine whether a stock is undervalued or overvalued for a price-earnings ratio. The P/E ratio lets you know how much you pay per share for $1 in earnings. To find the P/E ratio, simply divide a company’s stock price by its annual earnings per share (EPS), which is its net income divided by the shares outstanding.
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If a company had $100 million in annual net income with 50 million shares outstanding, its EPS would be $2. If its stock price is $50, the P/E ratio will be 25. This means that you pay $25 for every $1 annually in earnings.
To really get an idea of whether a stock is undervalued, you need to compare it to similar companies in its industry. For example, you will not compare nike with ExxonMobilor sweet green with Amazon. If several companies in the same industry have a price-earnings ratio within a close range of each other and you find one with significantly less, this may indicate that they are undervalued – and vice versa.
2. Price/Earnings to Growth (PEG) Ratio
The price-earnings-growth (PEG) ratio is similar to the price-earnings (P/E) ratio, except that it takes into account the growth of a company’s future earnings. To calculate the P/E ratio, you must first know the P/E ratio. Once you have the P/E ratio, you can divide it by the company’s earnings growth rate (EGR) over a specified period of time to get the P/E ratio.
For example, if a company has a 20 P/E ratio with an EGR of 10%, its PEG will be 2. A PEG ratio of less than 1 can mean the stock is undervalued, while a ratio above 1 can It means it is overrated. A firm with a price-return-growth ratio 1 has an ideal relationship between its market value and expected profit growth.
Let’s imagine a scenario in which two companies in the same industry have P/E ratios of 20 and 15, respectively. Only based on this, a company with a P/E ratio of 15 might look like a better buy, but if its EGR is 12% and the other is 25%, a company with a 20 P/E ratio is probably a better buy:
- Company A PEG: 15/12 = 1.25
- Company B peg: 20/25 = 0.8
3. Free cash flow
Free cash flow is the amount of money a business makes after paying for operating and capital expenditures (money used to purchase, maintain, or repair physical assets). Free cash flow is important because it is the money that businesses use to pay down debt, pay dividends, and make other investments to grow the business. You can find a company’s free cash flow by looking at its cash flow statement and subtracting capital expenditures from operating cash flow.
As a value investor, looking at a company’s free cash flow can often give you insight into how it will generate future profits. Strong or increased free cash flow usually comes before a profit increase and can indicate a company’s sales growth or lower costs. If a company is underpriced with increased free cash flow, it may mean that the market is still underpriced, but that may change once the free cash flow translates into higher profits in the future.
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John Mackie, CEO of Whole Foods Market, an Amazon company, is a member of The Motley Fool’s Board of Directors. Stefon Walters has no position in any of the stocks mentioned. Motley Fool has and recommends positions at Amazon and Nike. Motley Fool has a disclosure policy.