Investing-How to Buy an Undervalued Stock

18 Nov, 2009 | Written by Krishna Raavi | under Investing Fundamentals

When it comes to buying stocks most of us prefer to buy common stocks. But for many investors, buying preferred stock may be a good compromise between common stocks and bonds. That’s because preferred stock gives the investor the best of both worlds. Everyone wants to buy an undervalued stock, then how do you know if your preferred stock is undervalued or not? There are so many attributes to look for when you are trying to pick an undervalued stock to buy and to invest in. All of the choices and information available in this article can make trying to find a good stock at low price challenge. What makes a stock a good value to buy? What are the ratios you need to know before buying a stock? How do you know if you are buying a stock at low price or at the stocks peak? This article provides an overview of 5 most important ratios you need to consider before buying a stock.

Earnings per Share: Earnings per share is one of the important and easiest one where most financial sites provide , earnings per share (EPS) is one of the most important measure of a company’s strength. Obviously, the higher the number, the more money the company is making.

To calculate this ratio, simply divide the company’s net income by the number of shares outstanding during the same period. If the number of shares out in the market has changed during that period (ex. a share buyback), a weighted average of the quantity of shares is used.

For Example, Companies A and B earn $1000, but company A has 100 shares outstanding, so each share holder in effect earned $10. On the other hand, if company B has 500 shares outstanding and they too have earned $1000 then each share holder has earned $2. Thus it makes more sense to look at earnings per share (EPS), as a comparison tool.

EPS= Net Earnings/ Outstanding Shares

So looking at EPS ratio, you should go by company A with EPS of 10, right? EPS is not only the basics of comparing two companies, but it is one of the methods used.

Price-Earnings ratio (P/E Ratio): P/E ratio or the price per earnings ratio of the stock actually denotes how expensive this stock is. The ratio is calculated to make an estimate of appreciation in the value of a share of a company and is widely used by investors to decide whether or not to buy shares in a particular company.

P/E = market value per share/earnings per share (EPS)

Example: The market price of a share is $20 and earnings per share is $5,

Then the P/E =$20/$5=$4.

The market value of every one dollar of earning is four times or $4. The ratio is useful in financial forecasting. It also helps in knowing whether the share of a company are under or overvalued. For example, if the earning per share of ABC limited is $20, its market price $140 and earnings ratio of similar companies is 8; it means that the market value of a share of ABC Limited should be $160 (i.e., 8 × 20). The share of ABC Limited is, therefore, undervalued in the market by $20. In case the price earnings ratio of similar companies is only 6, the value of the share of ABC Limited should have been $120 (i.e., 6 × 20), thus the share is overvalued by $20.

The higher P/E ratio means that some investors are ready to pay more to acquire this stock; this also means that there are high expectations for that stock to perform. In case the company is not able to meet the expectations, then the investors are sure to lose money they invested in that company.

On the other hand, if the P/E ratio of the stock is low, the company is considered to be a low risk company since the earnings and expectations of that company will be relatively lower. If you want to compare the P/E ratios of various companies, be sure that you are comparing companies within the same sector or the industry.

PEG Ratio: Price per earnings to growth ratio is a widely used indicator of a stock’s potential value. It is favored by many over the price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued.

PEG=PE ratio/Annual EPS Growth.

The PEG Ratio of a company will be between 0 and 5. The lower the PEG Ratio, the better. A PEG Ratio of 2 or below is considered excellent. A PEG Ratio of 2 to 3 is considered OK. A PEG Ratio above 3 usually means that the company’s stock is overpriced. As with the P/E Ratio, never make a decision to buy a stock based solely on the PEG Ratio. Always thoroughly research a stock before making the decision to buy.

P/B Ratio: The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company’s book value to its current market price. Book value is an accounting term denoting the portion of the company held by the shareholders; in other words, the company’s total tangible assets less its total liabilities. The calculation can be performed in two ways, but the result should be the same each way. In the first way, the company’s market capitalization can be divided by the company’s total book value from its balance sheet. The second way, using per-share values, is to divide the company’s current share price by the book value per share (i.e. its book value divided by the number of outstanding shares).

Dividend Yield: A financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock. Dividend yield is calculated as follows:

Dividend Yield= Annual Dividends per Share/ Price per Share

To better explain the concept, refer to this dividend yield example: If two companies both pay annual dividends of $1 per share, but ABC Company’s stock is trading at $20 while XYZ Company’s stock is trading at $40, then ABC has a dividend yield of 5% while XYZ is only yielding 2.5%. Thus, assuming all other factors are equivalent, an investor looking to supplement his or her income would likely prefer ABC’s stock over that of XYZ.