Value investing is a strategy that can produce great returns when done correctly. When value investing, investors look for stocks whose price is trading below their intrinsic (true) value. For example, if a stock's intrinsic value is $100, but it's trading at $80, a value investor may invest, banking that one day the market will correctly price the stock, and then profiting at least 25% from the increase from $80 to $100.
A stock's price by itself doesn't tell you if it's cheap or not. A $5 stock can be expensive, just as a $5,000 stock can be cheap. If some penny stocks were $5 per share, many investors wouldn't touch them with a 10-foot pole. If Berkshire Hathaway Class A shares were $5,000, they'd likely be the most undervalued shares in history.
During bear markets, falling stock prices can sometimes cause stocks to "overcorrect," going from more than their intrinsic value to less than their intrinsic value, and leaving them at a bargain price for value investors. However, investors need to be careful when looking for undervalued stocks during these times, because it can be tempting to confuse low prices with low valuations.
That's why the price-to-earning (P/E) ratio can be super helpful during these volatile times in the market.
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Finding the P/E ratio
To calculate a company's P/E ratio, you must first know its earnings per share (EPS). A company's EPS is its profit divided by its number of outstanding shares. For example, if a company has 1 million outstanding shares and brings in $5 million in profit, its EPS would be $5. You can find a company's profit on its income statement, which publicly traded companies are legally required to file quarterly.
Once you know a company's EPS, it's easy to find its P/E ratio: All you have to do is divide its share price by its EPS. If a company's share price is $100 and its EPS is $5, its P/E ratio would be 20. The P/E ratio tells you how much you're paying for each dollar of a company's earnings. The higher the P/E ratio, the more you're paying for $1 of earnings.
Reading the P/E ratio
The most important thing to remember about a company's P/E ratio is that it's essentially useless by itself. To really get an idea of whether or not a stock is undervalued or overvalued, you must compare its P/E ratio to similar companies in its industry. You wouldn't compare Nike's P/E ratio to ExxonMobil's P/E ratio, but you could compare Nike to Under Armour or ExxonMobil to Chevron.
Some industries naturally have higher P/E ratios than others, so cross-comparing would likely be misleading. For instance, banking is an industry known for having low P/E ratios. However, if you looked at a construction company, whose industry is known for higher P/E ratios, and noticed its P/E ratio was low, you might think it was the deal of the decade.
If you're comparing similar companies and notice that one company has a P/E ratio noticeably lower than others, the stock is likely undervalued. If you're examining a company whose P/E ratio is much higher than similar companies, it's likely overvalued.
There are limitations to the P/E ratio
While it's a great way to find undervalued stocks, the P/E ratio isn't without its limitations. To begin with, the P/E ratio is usually calculated using a company's past earnings instead of its future earnings. The forward P/E ratio compares the current stock price to future earnings, but it's only an estimation; there's no way to know with 100% certainty what a company's earnings will be until those future earnings become a reality. An incorrect estimate could give investors the wrong picture of a stock, causing it to seem overvalued or undervalued when it's not.
Still, the P/E ratio has proven it's a great starting point for finding undervalued stocks, especially during a volatile time in the stock market. It may not be a one-stop shop for determining value, but in investing, nothing is. For just one calculation, it manages to give a lot of perspective about a stock, whether times are turbulent or calm.
