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Being able to find and invest in undervalued stocks is a great ability to have as an investor. Great companies can often fly under the radar or be underpriced by the market, and being able to identify those can pay off big with returns — just ask Warren Buffett, who’s made a fortune finding undervalued companies. If you’re looking to find undervalued companies, using these three metrics will help you.
1. Price-to-earnings (P/E) ratio
There aren’t too many metrics more commonly used to determine whether a stock is undervalued or overvalued than the P/E ratio. The P/E ratio lets you know how much you’re paying per share for $1 in earnings. To find the P/E ratio, simply divide a company’s share price by its annualized earnings per share (EPS), which is its net income divided by outstanding shares.
If a company has $100 million in annual net income with 50 million outstanding shares, its EPS would be $2. If its share price is $50, its P/E ratio would be 25. This essentially means you’re paying $25 per $1 per year 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 wouldn’t compare Nike with ExxonMobil, or Sweetgreen with Amazon. If several companies in the same industry have a P/E ratio within a close range of each other and you find a company with one drastically lower, that could signal it’s undervalued — and vice versa.
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2. Price/earnings-to-growth (PEG) ratio
The PEG ratio is similar to the P/E ratio, except it takes into account a company’s future earnings growth. To calculate the PEG ratio, you must first know the P/E ratio. Once you have the P/E ratio, you divide it by the company’s earnings growth rate (EGR) over a specific time to get its PEG ratio.
For example, if a company has a 20 P/E ratio with an EGR of 10%, its PEG would be 2. A PEG ratio less than 1 can mean a stock is undervalued, while a ratio above 1 can mean it’s overvalued. A company with a PEG ratio of 1 has a perfect relationship between its market value and projected earnings growth.
Let’s imagine a scenario where two companies in the same industry have P/E ratios of 20 and 15, respectively. Just based on that alone, the company with the 15 P/E ratio may seem like a better buy, but if its EGR is 12% and the other’s is 25%, the company with the 20 P/E ratio would likely be the better buy:
Company A PEG: 15/12 = 1.25
Company B PEG: 20/25 = 0.8
3. Free cash flow
Free cash flow is how much money a company has coming in after paying for operating expenses and capital expenditures (money used to buy, maintain, or fix physical assets). Free cash flow is important because it’s the money companies use to repay debts, 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 oftentimes give you insight into how future earnings may go. Strong or rising free cash flow usually comes before increased earnings and could indicate a company has sales growth or lowered costs. If a company is low-priced with increasing free cash flow, that could mean the market is still underpricing it, but that could change once the free cash flow translates into higher earnings down the line.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Stefon Walters has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon and Nike. The Motley Fool has a disclosure policy.
