There are many different types of investors: some focus on growth stocks, while others prefer dividend-paying stocks, and some look for value.
Value investors seek out stocks trading at a lower price than their intrinsic (or true) value. By finding companies whose stock price doesn't reflect their business or financials (like revenue and earnings), value investors hope to profit from the broader market underappreciating certain stocks. In other words, if a company's true value is $100 per share and it's trading at $80, value investors will invest, hoping that eventually the market will price it correctly at $100 and they'll make money (a 25% gain).
Investors must be careful not to confuse a cheap stock with a value stock because doing so could be costly. It could very well be the case that a $1,000 stock is undervalued and a $3 stock is overpriced. You always want to avoid a value trap, which is a stock that seems cheap but isn't. You'd regret buying lots of shares because they're inexpensive, only for it to turn out you're investing in a failing or stagnant business.
Using the P/E ratio to find undervalued stocks
A great way to determine whether a stock is under- or overvalued is by looking at the price-to-earnings (P/E) ratio, which tells you how much you're paying for each dollar of the company's earnings. You can find a company's P/E ratio by dividing its current stock price by its earnings per share (EPS). For example, if a stock is $100 and has an EPS of $4, its P/E ratio would be 25, meaning you're paying $25 for each $1 of earnings.
You can't look at the P/E ratio by itself to determine if a stock is undervalued; you need to compare it to similar companies within its industry. You wouldn't compare Apple (NASDAQ: AAPL) to ExxonMobil (NYSE: XOM) or Bank of America (NYSE: BAC) to Tesla (NASDAQ: TSLA), but you could compare Apple to Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG) or Bank of America to Wells Fargo (NYSE: WFC).
If you're looking at a company's P/E ratio and it's noticeably lower than other companies in its industry, that could be a sign it's undervalued. The opposite is also true. If a company's P/E ratio is in the 20s while the others in its industry are in the single digits, it's likely overvalued.
Finding value stocks isn't that simple
You'd be hard-pressed to find someone who doesn't like a good discount — that's what makes value investing appealing to many people. But if value investing were simple, everyone would be finding value stocks and making good investments. Unfortunately, that's not the case.
Value investing takes time and research. After all, you don't know if a stock is undervalued by just looking at its price; you need to research the company itself, as well as compare it to similar businesses to make that decision.
Value investing is a great way to minimize some of your risks and increase your chances of good returns, but it takes time to become a good value investor. If you're willing to put in the effort, it can pay off handsomely.
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 2/14/21
Bank of America is an advertising partner of The Ascent, a Motley Fool company. Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Stefon Walters has positions in Apple. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Apple, and Tesla. 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.