3 Metrics the Pros Use To Find Undervalued Stocks
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For most investors, a well-diversified portfolio of funds will do the trick. But if you want to try to identify winners like the pros on Wall Street, there are steps you can take.
Professional investors look at several metrics to determine if a stock is undervalued (though keep in mind that metrics alone don’t always tell the whole story). Here are three metrics you can assess.
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1. Price-to-earnings ratio
The price-to-earnings ratio, or P/E ratio, shows a company's stock price relative to its earnings per share. Undervalued stocks typically have a low price relative to how much money the company is earning.
The ratio calculated by dividing the stock price by the earnings per share. For instance, a stock worth $100 that has an annual $5 earnings per share has a 20 P/E ratio. A 20 P/E ratio doesn’t tell you much, but combining it with additional context will reveal if a 20 P/E ratio is excessive or a bargain.
Investors can compare a stock’s P/E ratio with its historical valuation to determine if it’s a good buy. A stock trading at a 20 P/E ratio may be a good buying opportunity if it has historically maintained a 25 P/E ratio, since it’s now considered cheaper. You can also look at the P/E ratios of competitors. For instance, if one bank has a 10 P/E ratio and another bank has a 15 P/E ratio, the bank with the 10 P/E ratio looks more undervalued, assuming both banks are growing at the same rate.
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2. Debt-to-equity ratio
A stock’s debt-to-equity ratio is a signal of a company’s financial health because it shows how much a company relies on debt. A high ratio could show that a company relies heavily on borrowed money, and tends to indicate risk. The debt-to-equity ratio is calculated by dividing total liabilities by total shareholders’ equity.
A good debt-to-equity ratio depends on the industry, but many consider a solid ratio to be below 1.50.
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3. Return on equity
Return on equity measures how effectively a company can turn shareholder capital into revenue growth. A high return on equity is a good sign and indicates that a company knows how to generate a positive return on investment (ROI) from the money it receives from investors.
Return on equity is calculated by dividing a company’s net income by the average shareholders’ equity. A good return on equity depends on the industry, and it’s smart to compare multiple companies’ ROEs.
A high return on equity can be a telltale sign of a good management team, and all of those extra returns can be reinvested into the business. These reinvestments can compound profits and translate into higher returns.
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