Use these 3 metrics to find undervalued stocks | Smart Switch: Personal Finance

(Stefon Walters)

Being able to find and invest in undervalued stocks is a great skill to have as an investor. Large companies can often go unnoticed or undervalued by the market, and being able to identify them can pay off big; just ask Warren Buffett, who made a fortune finding undervalued companies. If he is looking for undervalued companies, using these three metrics will help him.

1. Price-earnings ratio (P/E)

There are not too many metrics that are 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 stock price by its annualized earnings per share (EPS), which is its net income divided by shares outstanding.

If a company has $100 million in annual net income with 50 million shares outstanding, its EPS would be $2. If your stock price is $50, your P/E ratio would be 25. This essentially means you’re paying $25 for $1 per year in earnings.

To get a real sense of whether a stock is undervalued, you need to compare it to similar companies in your industry. For example, you would not compare Nike with exxonmobileeither 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 a drastically lower one, that could indicate that it is undervalued, and vice versa.

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2. Price/earnings-growth (PEG) ratio

The PEG ratio is similar to the P/E ratio, except that 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 specified time to get your PEG ratio.

For example, if a company has a P/E ratio of 20 with an EGR of 10%, its PEG would be 2. A PEG ratio of less than 1 may mean a stock is undervalued, while a ratio greater than 1 may mean it is undervalued. it’s overpriced. 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. On that alone, the company with a P/E of 15 may seem like a better buy, but if its EGR is 12% and the other’s is 25%, the company with a P/E of 20 probably the best. to buy:

  • Company A PEG: 15/12 = 1.25
  • Company B’s PEG: 20/25 = 0.8

3. Free cash flow

Free cash flow is how much money a business brings in after paying operating expenses and capital expenses (money used to buy, maintain, or repair physical assets). Free cash flow is important because it is the money companies use to pay down debt, 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 often give you an idea of ​​what future earnings may look like. Strong or rising free cash flow typically comes before an increase in earnings and could indicate that a business has increased sales or cut costs. If a company is underpriced with increasing free cash flow, that could mean the market is still undervaluing it, but that could change once the free cash flow translates into higher profits in the future.

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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 and recommends Amazon and Nike. The Motley Fool has a disclosure policy.

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