If you understand the terms overvalued and undervalued you will find plenty of stocks that look cheap
Stock investors are bargain hunting! From time to time, that is a title for a lot of news reports when it is a general market decline. For example, after the 2007/2008 prices have been cut by 40-60% so for sure there were some bargains out there.
People’s intuition about what is worth to buy can have dangerous side effects when it comes to investing. However, winning instincts can be very profitable. This is what the concept of value investing is all about.
People spend their money to buy expensive things in order to indicate status. But the other way is to get a good bargain. If you can combine both, it would be ideal. Having the status-symbol normally cost a lot, so we would like to get them at a good bargain. That sounds like a good deal.
The dogma that expensive things are better, forms human behavior in some unusual ways.
What is Bargain Hunting
For example in drug testing, patients mostly find they feel better if they know that the medicine that they use is more expensive. Incredible! That means that people instinctively look for bargains. They use price itself as information to estimate if something is a good bargain. That is indirect logic.
The defining value investing, hence, comes down to the simple concept of buying quality stocks that are undervalued. Not always the cheap is bad, and if something is expensive, then it isn’t always good. Bargain hunting means that a stock is worth less than it should be and is therefore undervalued. The ability to pick undervalued stocks or so-called value-investing is quite a talent. But is there really such a thing as an undervalued stock?
The stock price is a mixture of investors’ estimates for later growth. So, the opinion as to whether that stock is undervalued can be very questionable.
How the bargain hunting works
In less than 10 minutes reading about stocks you will come across the terms overvalued and undervalued. If you do a bit more examination, you will find plenty of stocks that look cheap to one financial theorist, but expensive to others.
How exactly can you calculate the value of a stock?
Well, it depends. There are a number of different metrics that may answer that question under different conditions. Here are some simple methods.
Use Price-earnings ratio (P/E)
The price-earnings ratio is one of the simplest valuation metrics. Just divide the price per share by earnings per share.
That’s the P/E. The lower the P/E, the less value it has.
Many investors like to use trailing 12-month earnings because they’re tangible results. But many like using calculations for the next period. Well, investors care most about the future, not what a stock’s already done.
Stock price = $30/share
Previous year’s earnings = $2/share
P/E = 15
Use price/earnings-growth ratio (PEG)
The utilities, for example, trade at low P/E, indicating low expectations for future growth. HiTech companies frequently trade at high P/E because investors are counting on fantastic growth. Price/earnings growth (PEG) is transforming growth expectations into the valuation. To calculate this you have to divide P/E by annual earnings per share growth. With PEG, less than 1 is rated undervalued, and anything over 1 is rated overpriced.
Stock P/E = 15
Estimated 5-year annual earnings growth: 15%
PEG = 1
Use price-sales ratio (P/S)
When some company hasn’t earned, it has revenues, after all.
A low P/S is cheap and a high P/S is expensive. For example, Twitter was flagged for having a high P/S early after its initial public offering. It was more than double of Facebook. But, that corrected thanks to disappointing results. Twitter’s P/S dropped from nearly 30 in December 2013 to about 5 as shares plunged more than 70 percent.
Stock price = $30/share
Previous year’s revenues = $5/share
P/S = 5
Use price-dividend (P/D)
Price-dividend is a less used metric, but it is quite good for measuring dividend stocks. To calculate, you have to divide the price by dividend. This ratio will tell you how much you have to pay to receive $1 in dividend payments. This is most useful in comparing a stock’s value against itself or against other dividend payers.
Stock X price = $30/share
Previous year’s dividend = $1/share
P/D = 30
Enterprise value-sales is an alternative to price-sales, just like Enterprise value-EBITDA is an alternative to P/E. But you can use them, of course.
The most important, all this is in the future, so you have no control over it.
The only thing you can control is the price at which you can buy the stock. Moreover, whether you buy it at all at a settled price. Everything that happens in the future is in the shadow of the price. The same investment can be good or bad depending on what price you paid.
How to find bargain hunting?
Let’s say, it is impossible to estimate an investment without the context of its price. There are equity investments which are bad despite the price. Still, there aren’t any investments that are good despite the price. If there is no bargain to be had, the instinct of buying only at a bargain is the most important thing in investing.