How to Find Undervalued Stocks? Here’s Where I Start.

There are many different styles that people choose when investing. One of these styles is value investing, which looks for stocks that are trading below the price they’re actually worth.

This can be as complicated as determining the intrinsic value of a stock. For example, if a company is trading at $100 per share and an investor believes its intrinsic value is $125, he would invest and hope the stock market eventually values ​​it at $125 and he 25% made profit.

But there are also easy ways to apply value investing principles. When looking for undervalued stocks, look no further than a company’s price-to-earnings multiple.

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Don’t forget the income

The price-to-earnings ratio, or P/E, is useful because it tells you how much you’re paying for every dollar of a company’s earnings. You can find a company’s P/E by dividing its current stock price by its earnings per share (EPS). For example, if a stock trades at $100 and has earnings per share of $5, its P/E would be 20, meaning you’re paying $20 for every $1 of earnings.

The P/E alone does not tell you anything about the value of a share, since different industries naturally have different P/E ratios. A key reason is that investors in companies in higher-growth industries are more willing to pay a higher price now for future growth. For example, the banking industry typically operates at low P/E ratios, while healthcare is typically much higher. That’s why you wouldn’t compare JPMorgan Chasethe price-earnings ratio Johnson and Johnson‘s, or Appleis to Walt Disney‘S. But you could compare it to JPMorgan Goldman Sachsor Apple too Microsoft.

If you’re studying a company and its P/E ratio is significantly lower than other companies in its industry, it could be undervalued — for example, if a company has a P/E ratio in the 10s range but peers are in the 20s or 30s range. It’s important to understand why — as we’ll address in the next section — but if you’re looking for undervalued stocks, this is reason to do some research.

Understand the why behind a company’s P/E

Let’s use alphabet (GOOGL -0.24%) as an an example. At current rates, the company has a P/E ratio of around 23, less than half what it was five years ago. That tells you the stock is cheaper than it has been in recent years. That doesn’t necessarily make it underrated. However, if you zoom out and compare it to other big tech peers, the argument can be made that it’s undervalued in comparison.

DATA FROM YCharts

Because P/E ratios go down when stock prices go down, it’s equally important to understand this Why behind a stock’s current levels. You want to make sure it’s really undervalued and not a rightfully priced bad investment.

A look at Alphabet’s EPS history shows that earnings growth has slowed recently. But it’s not the only company in this position, and its growth in recent years has still been strong.

DATA FROM YCharts

Alphabet’s declining spending on digital advertising could be one reason the market has gone sour. But one could argue that macro conditions don’t justify the company’s losing more than 25% of its market value over the past year — especially given its track record.

What next?

P/E isn’t the final word on whether or not a stock is undervalued. But understanding what it tells you about market sentiment is a good starting point for your research.

In the case of Alphabet, you might also ask:

• What Could Continue to Drive Alphabet’s EPS Growth Going Forward?
• With the S&P 500’s P/E ratio recently hovering around 18, will Alphabet grow so much faster that it deserves a higher multiple?

Everyone likes a good value or discount, especially in the stock market. That’s the biggest appeal behind value investing. It takes time and research, but using a metric like P/E gives comparatively much more insight — not just into a specific company, but its competitors and the industry in which it operates.