There are many investment strategies you can adopt to help you reach your financial goals. One approach is to find fundamentally sound companies that the market has undervalued. A company’s stock price is not always reflective of its intrinsic value, and investing in undervalued companies — while not the only means of finding a good investment — is a great way to put yourself in a position to succeed in the long run. That said, here are four metrics that can help you find undervalued companies.
Image Source: Getty Images
A company’s P/E ratio is one of the best figures to use when determining whether or not a company is undervalued or overvalued. To find a company’s P/E ratio, you must first know its earnings per share (EPS). You can find the EPS by dividing a company’s profits by the number of outstanding shares. Then, take the company’s stock price and divide it by the EPS to find the P/E ratio. The higher the P/E ratio, the more expensive a stock is relative to its earnings.
Knowing a company’s P/E ratio isn’t enough by itself to determine if a stock is undervalued; it all depends on the industry and the P/E ratio of similar companies. For example, you wouldn’t compare Google’s (NASDAQ: GOOGL)(NASDAQ: GOOG) P/E ratio to Nike’s (NYSE: NKE); you would likely want to compare it to a similar tech company like Apple (NASDAQ: AAPL). If companies in an industry have a P/E ratio between 25-30 and you find a similar company with a P/E ratio around 15, it’s likely undervalued — and vice versa.
A large part of investing is understanding the growth potential of a company. This is where the PEG ratio comes in handy. The PEG ratio is similar to the P/E ratio, except it emphasizes a company’s future growth potential versus its past performance.
You can find a company’s PEG ratio by taking its P/E ratio and dividing it by its earnings growth rate for a specific period. For example, let’s say a company’s P/E ratio is 20 and its EPS this year and last year was $3.50 and $2.75, respectively.
First, you would find the earnings growth rate by dividing the current EPS by past EPS and then subtracting one. Once you have this number, convert the number to a percentage.
Earnings growth rate = ($3.50 / $2.75)-1 = 0.27
0.27 = 27%
Next, you would divide the P/E ratio by the earnings growth rate (the whole number, not the percentage).
20 / 27 = 0.74
PEG ratio = 0.74
If you did the same with a similar company in the same industry and got a PEG ratio of 1.3, you could conclude that the company with the lower PEG is a better value because you’re paying less for increased earnings growth.
The P/B ratio is used to compare a company’s market capitalization to its book value. You can find a company’s P/B ratio by taking its share price and dividing it by its book value (assets minus liabilities) per share. A P/B ratio under one is usually an indication of a potentially undervalued stock because it means the market is valuing a company less than its on-paper value.
You can find assets and liabilities to use in your calculations by going through a company’s financials. Or, a simple online search can usually lead you to a figure you can use.
Free cash flow — which can sometimes be mistaken with profit — is the measurement of how much money is coming into a business versus going out. If a company has more money coming in than going out, it’s considered cash flow positive; if it has more money going out than coming in, it’s considered cash flow negative.
Taking a company’s market capitalization and dividing it by its free cash flow will give you its price to FCF. The lower this number, the more a stock is considered undervalued because it means you’re paying less for more cash flow. And generally speaking, an increase in cash flows precedes an increase in earnings.
Ideally, you’ll want to look for companies with a FCF ratio less than 10.
As with most, if not all, equity metrics used to help make investing decisions, it’s important not to take a single number as-is. One of the more important aspects is knowing what to compare these numbers to, and a good rule of thumb is always to compare similar companies in the same industry.
While valuation is important to consider when choosing a stock, it’s not the only factor. Before making investing decisions, please do your research to make sure the company is a sound investment that fits your investment strategy. Doing so should put you on a path toward growing your money and accomplishing your financial goals.
10 stocks we like better than Walmart
When our award-winning analyst team has an investing tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*
They just revealed what they believe are the ten best stocks for investors to buy right now… and Walmart wasn’t one of them! That’s right — they think these 10 stocks are even better buys.
Stock Advisor returns as of 6/15/21
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, and Nike. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.
