If you’re building your long-term portfolio and you want it to have high growth potential, you’re looking for undervalued stocks.
But how do you know if a stock is undervalued? Fortunately, you can use a handful of indicators. Below we check out the four most common. Ready? Go!
The price/earnings (P/E) ratio compares a stock’s price against how much profit the company actually makes.
To calculate it, we take the current price of a stock and divide it by the company’s earnings-per-share number. The lower the P/E, the better, because you’re paying less for the amount of profit the company is able to generate.
Usually, the P/E of the company is compared to the average of its industry. For example, Ford’s P/E ratio is compared to the average of other car-makers. If it’s below average, it’s a good sign.
However, this indicator is not reliable in signaling undervalued stocks when we evaluate startups, which generally have a very high expected growth but do not yet make profits.
The Price-to-Book (P/B) ratio compares the stock price to the total value of a company’s assets, or “book value”.
To get this ratio we compare share price to net assets per share. This indicator tells you how much you’re paying for a slice of the company’s tangible (actually resalable) property.
In other words, it tells you how much of the money you’re getting back in your pocket if the company was liquidated tomorrow. If it’s between 0 and 1, the company may well be undervalued.
However, the price/book tends to underestimate companies with intangible assets (like patents, copyright, brands), because this type of property isn’t considered in the calculation.
This is the ratio between the annual dividends of a company and its current stock price. The higher the dividend/price ratio of a security, the higher the annual return you can expect from it, no matter what the price. In theory, anyway.
That’s why long-term investors should definitely take this indicator into account. But beware! This number can go high simply because the share price is falling, which usually means the dividend will soon be cut.
The indicators above are good for getting a sense of a stock’s value *right now.* But we all know that, when looking for undervalued stocks, investors should take into account a company’s future earnings potential.
That’s where PEG comes in. It uses the P/E ratio from above but also takes the company’s expected growth rate into account, usually for the next five years*.
To calculate PEG, we take the P/E ratio and divide it by the expected earnings growth rate. It’s a more complete indicator of the P/E, and in general, it’s considered the most reliable index for figuring out whether a company is undervalued or not. For this reason, we’ll use it below to find five undervalued shares on BUX.
The lower the PEG, the more the company’s shares are considered cheap. If the indicator is between 0 and 1, the company is probably undervalued. When it’s more than 1, it could be overvalued. If it’s negative, it means the company is at a loss, or that its profits are expected to decrease! In this case: run away!
All views, opinions or analysis expressed in articles are that of the author and do not represent the views of BUX. Neither BUX nor the author provide financial advice and these articles should not be construed as such.