At the beginning of the COVID-19 pandemic in early 2020, the stock market plunged. All three major indexes -- the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average -- fell 30%, 29%, and 34%, respectively, from mid-February to mid-March 2020. However, from then until the end of 2021, the stock market rallied and put on an impressive bull run. The S&P 500 increased 106%, the Nasdaq Composite increased 127%, and the Dow Jones increased 89%.
But then 2022 came, and reality in the form of a stock market correction hit. A stock market correction occurs when major indexes drop 10% to 20% (over 20% is considered a bear market). Although nobody likes seeing their portfolio value drop, stock market corrections can sometimes be good for long-term investors because great companies trade at lower prices.
However, investors need to look out for one thing during these times: value in disguise.
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Don't confuse price and value
Value investing is a strategy in which investors look for stocks priced below their intrinsic (or true) value, which is based more on a company's financials like revenue and profit. When investing in undervalued companies, investors hope one day the stock market prices the stock correctly, and they, at minimum, profit from that gain. For instance, if a stock is trading at $75 and a value investor believes its intrinsic value is $100, they would invest, hoping it reaches $100 and they could make a 33% return on investment.
Since stock prices in general have dropped in 2022, many more "cheap" stocks are out there -- cheap meaning strictly in price, not in value, and that's where some investors go wrong.
Just because a stock pice is low doesn't mean it's a good deal. There are overvalued $3 stocks, just as there can be undervalued $300 stocks. For example, it would be questionable for some penny stocks to be priced at $3. However, another stock might be undervalued by many investing standards even if it traded for $300 or even $3,000 per share. Stock price alone is irrelevant when trying to determine value.
Finding undervalued stocks
A great way to determine whether a stock is undervalued (or overvalued) is by looking at its price-to-earnings (P/E) ratio. 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 $200 and has an EPS of $10, its P/E ratio would be 20. This means if you buy a share, you're paying $20 for each $1 of the company's earnings.
The higher the P/E ratio, the more "expensive" a stock is, but you can't look at a company's P/E ratio by itself to determine value; you need to compare it to companies within the same industry. Some industries have P/E ratios that are naturally low or high, and if you make the mistake of comparing companies from different industries, you could get the wrong idea about a stock. You can't compare big oil to big banks, or big tech to big pharma. It needs to be apples to apples.
Microsoft has a P/E ratio of 28.6. If you compare that to Bank of America's 10.7 P/E ratio and Goldman Sachs' 7.6 P/E ratio, you'd think Microsoft was vastly overvalued. However, when you compare it to Apple's 27.6 P/E ratio, the comparison makes way more sense.
If a stock's P/E ratio is drastically lower than comparable companies, it's worth a closer look to see if it's undervalued.
It takes more time
Finding undervalued stocks isn't always easy or straightforward. If it were, many more investors would shift their focus there. Value investing takes more research than other "set-it-and-forget-it" strategies -- like investing in a few broad index funds -- which inevitably means it takes more time.
You don't have to spend hours every week going through financial statements (you can do a quick internet search and find a company's P/E ratio), but you will have to do more than just taking a stock's price at face value to determine worth. This extra bit of effort can pay off tremendously.
