Whether you are a growth stock investor or a value stock investor, you should always be looking to get the best value when you purchase a stock. As a financial professional it frustrates me when I hear an investor say, “I’m not concerned about value, because I’m a growth investor.” I understand the power of investing in stocks growing at a rapid pace, but I also know that your entry price definitely matters a great deal. How can you go about finding a good value in the stock market?
Four Ways to Spot an Undervalued Stock
1. Figure out the PEG Ratio of the Stock- I am firm believer in the fact that valuation ratios do matter. There is no single valuation measure which tells you that a stock is a buy or sell, but a great starting point is calculating the PEG ratio of a stock. This is done by taking the price/earnings ratio and dividing it by the expected growth of the company over the next five years. A ratio of 1 or less is considered a growth stock that sells for a cheap price. I strongly suggest using this as part of your analysis.
2. Historical Valuations- It is always wise to take a look at historical valuations compared to today’s valuation. Mature companies that have consistently performed through many economic cycles can sometimes be sold off unfairly because of current broader market conditions. If a blue chip stock is trading at 10 times forward earnings when it has historically traded at 15 times earnings, it may well be worth a look.
3. Industry Leaders- It is always wise to heed the advice of someone like Warren Buffett. Buffett places a high level of importance on economic moat and whether a company has a continual competitive advantage. How can you find a value in these stocks? I suggest looking for companies who constantly outperform their peers in earnings growth and cash flow. These industry leaders should trade at a premium to their competitors, and when they aren’t, consider it a solid chance to get involved.
4. Use Your Own Knowledge and Find Innovative Companies- This is probably the most difficult way to spot a cheap stock, but it can also be the most rewarding. If you are able to find a company that is extremely innovative and changing the way business is done, you should always give it a second look. I suggest looking for companies in your particular field of work that are leading the way. As the great mutual fund manager Peter Lynch often says, “Invest in what you know.”