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Finding Undervalued Stocks Using Valuation Metrics

Undervalued StocksFinding undervalued stocks is not nearly as difficult as many stock market traders and investors think.  There are a number of reliable stock valuation metrics that can be utilized to find undervalued stocks.  The important thing to remember about undervalued stocks is that just because a stock is inexpensive in regards to its nominal price, it is not necessarily undervalued.  Conversely, just because a stock appears expensive based on the price that it trades at, it is not necessary an overvalued stock, and may in fact be undervalued.

The most basic and common way to value a stock is to look at the stock’s Price-to-Earnings ratio (P/E ratio).  The P/E ratio is a stock valuation metric that is determined by dividing the current price of a stock by reported company earnings per share (outstanding shares) for the past year, which is known as trailing earnings.  Undervalued stocks generally have a low P/E; however, this is not the only stock valuation metric that a stock trader or investor should look at when assessing a stock’s valuation since the P/E ratio uses past earnings.

The PEG ratio takes the P/E ratio a step further and divides the estimated the P/E ratio for the coming year by the expected earnings growth rate for a stock in the coming year, which is something that must be taken under consideration when looking for undervalued stocks.  The G in the PEG ratio is for growth.  A stock’s PEG ratio is calculated by taking a stock’s current P/E ratio based on estimated forward earnings for the upcoming year and dividing it by the estimated earnings growth rate for the upcoming year.

For example, if a company earned $1.00 per share during the past year, but is expected to earn $1.50 per share during the upcoming year, the earnings growth rate (G) is 50%.  If the company’s stock currently sells for $20 per share, it would have a P/E ratio of 20 based on the $1.00 per share earnings per share over the past year.  Using a P/E ratio of 15 or above as a broad measure of stocks that are overvalued, the stock would appear to be overvalued, based on the P/E ratio valuation metric.  However, plugging the P/E ratio for this stock into the PEG ratio stock valuation metric, by dividing the P/E ratio of 20 by the G of 50 (based on the expected 50% earnings growth rate) yields a PEG ratio for the stock of 0.4

The PEG ratio uses 1.0 as the threshold for separating undervalued stocks from overvalued stocks.  Stocks with a PEG ratio of less than 1.0 are considered undervalued stocks due to their expected high earnings growth rates, which should push the price of the stock up in the coming year.  In the example above, the PEG ratio of 0.4 indicates the stock is very undervalued based on its expected forward looking growth rate, despite its current trailing P/E ratio of 20.

Undervalued Stocks – Avoid Value Traps

The most important thing for a stock market trader or investor to keep in mind when looking for undervalued stocks is that there are stocks that appear undervalued based on their P/E ratio, but are actually “value traps” that have no likelihood of trading higher because the earnings side of their valuation has no prospects of improving in the foreseeable future.  This is why using other stock metrics, such as the PEG ratio, is so important.  A stock’s P/E ratio is a nice snapshot of where the stock has been in regards to price and earnings over the past year, but is not the only stock valuation metric that should be used to find undervalued stocks.  To find truly undervalued stocks, one must look forward at anticipated future earnings and the anticipated future earnings growth rate to properly assess the future value of a stock and its potential to move higher in the future.

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