When stock analysts talk about a stock being either undervalued or overvalued, they're most likely using any one of many valuation models that attempt to predict a stock's direction. Undervalued stocks are expected to go higher; overvalued stocks are expected to go lower, so these models analyze many variables attempting to get that prediction right. However, the data point that all the models have in common is a stock's price-to-earnings ratio.
The price-to-earnings ratio is one of the main metrics investors use to decide if a stock is properly valued. It is calculated by dividing a stock's price by its trailing 12 month earnings per share. If a stock is trading for $5 and its earnings in the past year were $1, its P/E ratio would be 5. In stock market jargon, the stock would be said to be trading at five times earnings.
Comparing P/E Ratios
Once you know the P/E ratio for a stock, you should compare that to the P/Es of other companies in that industry and get a sense of what the average P/E is for the group. If most of the companies have a P/E of around 20 and the company you're interested in has a P/E of 10, this may indicate that the stock is undervalued. If a company has a P/E that is much higher than the industry average, you can assume its overvalued. There are exceptions to these rules.
Research Low P/Es
A company that has a low P/E ratio may actually be undervalued, or there may be a very good reason for its low valuation. For example, it could be in financial trouble or have legal or labor problems. There are many reasons why a stock's P/E is low and only one of them is that its actually undervalued. Always research the stock you're buying to find out if its truly undervalued or its low valuation is due to some other cause.
High as a Buy
Just as a low P/E might not necessarily indicate that a company is a good value, a high P/E does not always mean a stock is overpriced. Its possible the company took a one-time loss that is unlikely to be repeated or has some other temporary problem that is impacting earnings in the short-term. Also, a company might have a high P/E because it has very high future expected growth. If a company with a high P/E has just rolled out a new product that is expected to double or triple earnings, that high P/E might be justified, which why its also important to look at forward P/E.
Forward P/E price per share is divided by its projected future earnings instead of current earnings. Some investors feel this metric gives a more accurate picture of the undervaluation or overvaluation of stock. However, you should note that this data is based on educated estimates and calculations from industry analysts.
Wayne Marks has more than 20 years of experience in finance, education, public relations and marketing in both New York City and Washington, D.C. He has worked for corporate and nonprofit organizations and holds a certificate from the Wharton School of Business.