There are many different styles people take when approaching investing. One of those styles is value investing, which is looking for stocks trading below the price they're really worth.
This can be as complicated as determining a stock's intrinsic value. For example, if a company is trading at $100 per share and an investor believes its intrinsic value is $125, they'd invest, hoping the stock market eventually prices it at $125 and they'll have 25% gains.
But there are simple ways to use value investing principles, too. If you're looking to find undervalued stocks, look no further than a company's price-to-earnings ratio.
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Don't forget about the earnings
The price-to-earnings ratio, or P/E ratio, is helpful because it tells you how much you're paying for each dollar of a company's earnings. 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 trading at $100 and has an EPS of $5, its P/E ratio would be 20, meaning you're paying $20 for each $1 of earnings.
The P/E ratio alone won't tell you a stock's value, because different industries naturally have different P/E ratios. A large reason is that investors of companies in higher-growth industries are more willing to pay a higher price now for future growth. The banking industry, for example, typically operates with low P/E ratios, while healthcare is typically much higher. That's why you wouldn't compare JPMorgan Chase's P/E ratio to Johnson and Johnson's, or Apple's to Walt Disney's. You could, however, compare JPMorgan to Goldman Sachs, or Apple to Microsoft.
If you're examining a company and its P/E ratio is noticeably lower than other companies in its industry, it could be undervalued -- for instance, if a company has a P/E ratio in the 10s but competitors are in the 20s or 30s. It's important to understand the reasons why that might be -- as we'll touch on in the next section -- but if you're looking for undervalued stocks, it's a reason to investigate.
Understanding the why behind a company's P/E ratio
Let's use Alphabet (GOOGL -1.97%) as an example. At recent prices, the company has a P/E ratio hovering around 23, less than half as much as just five years ago. That tells you the stock is cheaper than it's been in recent years. That doesn't necessarily make it undervalued. However, when you zoom out and compare it to other Big Tech peers, the argument can be made it's undervalued by comparison.
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Since P/E ratios decrease when stock prices decrease, it's equally important to understand the why behind a stock's current levels. You want to ensure it's truly undervalued and not a justly priced bad investment.
A glance at Alphabet's EPS history shows profit growth has slipped lately. But it's not the only one in that position, and its growth in recent years has still been strong.
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Alphabet's slowing digital ad spending could be a reason why the market has soured. But an argument could be made that with macroeconomic conditions, it doesn't warrant the company losing more than 25% of its market value over the past year -- especially given its track record.
What next?
The P/E ratio isn't the final word on whether a stock is undervalued or not. But understanding what it's telling you about market sentiment is a good place to start your research.
In the case of Alphabet, you might also ask:
- What could drive Alphabet's EPS growth higher in the future?
- Since the S&P 500's P/E is around 18 lately, 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 most of the appeal behind value investing. It does take time and research, but using a metric like the P/E ratio comparatively gives much more insight -- not only into a specific company, but also its competitors and the industry it operates in.
