Warren Buffett, as a brilliant stock-picker, staked his reputation on favoring value stocks and purchasing shares in companies he saw as priced below their true value, while generally avoiding investments in overvalued stocks. His Berkshire Hathaway stock portfolio consistently outperforms the broad market, so a strategy that works for Buffett just might work for you.
A key data point that analysts use to determine whether a stock is under or overvalued is its price to earnings (P/E) ratio. To determine the ratio, take the current stock price, or its market value per share, and divide it by the company’s annual earnings, or the earnings per share. Another data point -- the PEG score -- consists of the P/E score divided by growth rates.
Stocks with a low P/E ratio or PEG ratio may be considered value stocks. Higher P/E ratios might indicate a company expected to achieve high growth, which would categorize it as a growth stock rather than a value stock. A high P/E ratio also serves as a possible sign of overvalued stock.
A PEG ratio below 1 could indicate an undervalued stock, while a ratio over 1 might signal an overvalued stock. Compare P/E and PEG ratios to competitors or other similar industry stocks, rather than to the broad market, as some industries tend to have higher or lower overall valuations than others.
Finding Undervalued Stocks
Most online brokerage firms have stock-screening tools available to the general public. Even if you don't have a brokerage account with the firm, such tools can help you determine which stocks to avoid. Some value stock investors look at entire industries currently out of favor or at companies that have experienced recent troubles. For example, some non-high tech stocks became relatively undervalued during the dotcom boom from 1999 to 2000. Another example would be Toyota in the months that followed safety recalls in 2009, when its stock price tumbled.
While valuation rates as an important factor in stock picking, it isn’t the only consideration. Even Buffett advises that “it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price.” He does seek high returns by purchasing undervalued shares, but he also sticks to solid companies. In addition to looking at valuations, investors should look for creditworthy companies with strong profits and profit potential. Take care, however, before buying overvalued stocks -- the higher they are, the harder they could fall.
- Motley Fool: The Most Undervalued Stocks in the Market
- CNBC: Cramer on Banks – The Market’s Most Undervalued Stocks
- MSN Money: Create Your Own Stock Search
- NASDAQ: Finding Undervalued Stocks in the Technology Industry
- Forbes: Whitman Sampler of Value Stocks
- The Tech Journal: Share Value of Toyota Dropped 20% for Recall
- NASDAQ: Glossary
- Comstock Images/Comstock/Getty Images
- Expensive Vs. Cheap Stocks
- How to Choose Stocks to Trade
- John Bogle's View on Dividend Investing
- How to Invest in Common Stocks
- How Do I Decide If a Stock Is Worth Buying?
- What Happens to Stock Prices if the EPS Increases?
- How do I Evaluate the Performance of Stock Market Investments?
- Value Stock Vs. Growth Stock Long-Term Return