With these 3 key figures you can find undervalued stocks

Important points

  • You should compare the price-to-earnings ratio of companies in the same industry.
  • A PEG ratio below 1 may be an indication of an undervalued stock.
  • Free cash flow usually comes before earnings increase.

The ability to find and invest in undervalued stocks is a great ability to have as an investor. Large companies often go under the radar or are undervalued by the market, and if you are able to spot them, it can translate into big returns – just ask Warren Buffett, who made his fortune looking for undervalued companies. If you are looking for undervalued companies, these three measurements will help you.

1. Relationship between price and earnings (P / E).

There are few metrics that are more commonly used to determine if a stock is undervalued or overvalued than P / E. P / E tells you how much you pay per share for $ 1 in earnings. To find P / E, simply divide a company’s share price by annual earnings per share. share (EPS), which is net income divided by outstanding shares.

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If a company has $ 100 million in annual net income and 50 million outstanding shares, its earnings per share will increase. share be $ 2. At a stock price of $ 50, the P / E is 25. That means you pay $ 25 for every $ 1 in annual earnings.

To really find out if a stock is undervalued, compare it with similar companies in the industry. You would, for example Nike not provided ExxonMobil or sweet green not provided Amazon to compare. If several companies in the same industry have P / E ratios that are in a narrow range, and you find a company whose P / E ratio is drastically lower, it may be a sign that it is underestimated – and vice versa .

2. Price-to-earnings growth ratio (PEG)

The PEG ratio corresponds to P / E, but takes into account a company’s future earnings growth. To calculate the PEG ratio, you must first know the P / E ratio. Once you know the P / E, divide it by the company’s earnings growth (EGR) over a period of time to get the PEG ratio.

For example, if a company has a price-to-earnings ratio of 20 and an EGR of 10%, its PEG is 2. A PEG ratio of less than 1 may mean that a stock is undervalued, while a ratio above 1 means that it can be overestimated. A company with a PEG ratio of 1 has a perfect ratio between its market value and expected earnings growth.

Let’s imagine a scenario where two companies in the same industry have P / E ratios of 20 and 15, respectively. For that reason alone, the 15 P / E company may seem like a better buy, but if its EGR is 12% and the other company is 25%, the 20 P / E company would probably be a better buy:

Company A PEG: 15/12 = 1.25
Company B PEG: 20/25 = 0.8

3. Free cash flow

Free cash flow shows how much cash a company has left after paying for operating expenses and capital expenses (money used to buy, maintain or repair tangible fixed assets). Free cash flow is important because it allows companies to use this money to repay debt, pay dividends and make other investments to grow the business. You can find a company’s free cash flows by looking at the cash flow statement and subtracting capital expenses from the operating cash flows.

As a value investor, looking at a company’s free cash flow can often give you a clue as to how future earnings may develop. Strong or increasing free cash flows usually precede an increase in earnings and may indicate that a company has revenue growth or declining costs. If a company is priced low when free cash flow increases, it may mean that the market still undervalues ​​the company, but that may change when free cash flow translates into higher earnings.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fools’ board of directors. This article was written by Stefon Walters and was published on Fool.com on 6/9/2022. It has been translated so that our German readers can participate in the discussion.

The Motley Fool owns shares in and recommends Amazon and Nike.

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