How to Find a Good Value Stock

Finding a stock that’s a good value isn’t as easy as it sounds.  Sure, you can look at simple valuation metrics like price to earnings ratio to help you pick, but if you look at only one metric then you’ll likely miss out on many stocks that are actually a better value.  After all, what does value mean?  In my eyes, it means that the stock is attractively priced relative to its future return potential.  Future returns rely not just on today’s price valuation, but also based on tomorrow’s earnings and the reputation that the stock develops over the years.  For that reason, we’ve outlined three important aspects to look for in picking a stock that is a good value.  Let’s start with the price to earnings ratio.

Does A Low P/E Ratio Mean a Stock is a Good Value?

Typically, the group of investors known as value investors prefer stocks that have low price to earnings ratios.  That’s because, relative to their earnings, these stocks are a good value.  After all, if all other metrics are equal, a stock with a lower P/E is more attractively priced than the same company that trades with a higher P/E.  Furthermore, there has been lots of empirical evidence collected that proves that lower P/E stocks have higher returns over the long run.  Over the last fifty years, the 10 percent of stocks with the lowest P/E ratios returned an average of around 16% per year, while the 10 percent of stocks with the highest P/E ratios returned an average of about 7%.  While these may be facts, there are circumstances that can help explain this phenomenon.  For example, during the dot com days, stocks would start trading at P/E ratios in the hundreds or thousands.  When the bubble burst, many of these stocks lost nearly 100% of their value.  I’m guessing some effects like these skew the numbers some.  Also, having faced some big recessions and crises over the past decade, lower priced stocks have been more in fashion than the high P/E stocks.  After all, even Apple and Google could be considered low P/E stocks these days.

Indeed, if you are looking for a good stock value, you should definitely include low P/E stocks in your search.  However, I wouldn’t limit your search to just low P/E stocks.  That’s because other factors also make stocks a good value.  This brings us to our next category of stocks that may offer good long term value – low PEG stocks.

Using A Low PEG Ratio to Find a Good Value Stock?

While most traditional value investors stick to stocks with low price to earnings ratios, there is another group of investors that look for good stock values based on PEG ratios.  The PEG ratio is a metric that compares the PE ratio to the expected growth of a company.  Investors that use this type of ratio as their main investment philosophy are often called GARP investors, which stands for Growth At a Reasonable Price.  The investment strategy is to look for stocks that trade at a good value.  By using this metric, both low P/E and high P/E stocks are included in any stock screens, and stocks that have high growth rates relative to their valuations are favored.  Let’s look at an example of how to use PEG ratio to find a stock that is a good value.

Let’s assume we are interested in two stocks.  Stock A is trading at $5 and has earnings of $1 per share.  It is expected to grow its earnings by 5% per year.  Stock B is trading at $10 and has $1 in earnings per share, but it is expected to grow at 20% per year for the foreseeable future.  Now, let’s look at some of the valuation metrics for these two stocks.  Stock A is trading at a P/E of 5 and Stock B is trading at 10.  On a strict P/E basis, Stock A appears to be a much better value than Stock B.  However, valuing solely on P/E leaves out the growth factor.

Now, let’s use PEG ratio to compare these two stocks.  Stock A has a PEG ratio of 1.0 (PE of 5 divided by growth of 5% = 5/5 = 1.0) and Stock B has a PEG ratio of 0.5 (PE of 10 divided growth of 20% = 10/20 = 0.5).  As you can see by this valuation metric, Stock B is twice the valuation based on PE but only half the valuation of Stock A based on PEG ratio.  In this case, all else equal, I would choose Stock B as my investment choice based on value.  Here’s why.

Currently, both stocks earn $1.00 per share.  However, in five years, given their projected growth, Stock A will earn $1.28 per share ($1.00 x 1.05^5) while Stock B will earn $2.49 ($1.00 x 1.20^5).  Now, let’s assume that in five years both stocks trade at the same P/Es they started at.  That would mean that Stock A would trade at $6.38 (PE of 5 times EPS of $1.28) while Stock B would trade at $24.88 (PE of 10 times EPS of $2.49).  In this case, Stock A returned 27.6% over the five years, while Stock B returned a whopping 148%.  In reality, many fast growing stocks slow down over the years and when they do, their P/E ratios fall back in line with their growth.  However, using the PEG ratio to help find attractively valued stocks is a great way to invest, at least in theory.

Before you start buying based on P/E’s and PEG ratios, you should look at one last factor that can help you choose the stocks with the best value.  This factor is the qualitative aspect of a stock.  The next section explains what we mean by this.

Consistent and Reliable Earnings Really Matter!

The qualitative aspect of stock valuation is perhaps more important than the quantitative aspect of finding a good value stock.  Usually, if a stock is trading at a low PE relative to other similar stocks, its for a good reason.  Perhaps the management team is inexperienced.  Maybe the quality of their product compared to their peers is below average.  Maybe the financial accounting applied to the company’s earnings are too aggressive and produce poor quality earnings.  Maybe the company just isn’t as good as the other companies in its industry.  Usually, if a stock value looks too good to be true, it is!  In fact, I’d say that is the case for nearly 99% of all stocks.

When you look for good long term prospects, don’t just look at the cheapest stocks based on P/E or other valuation metrics.  Also, don’t just look at the stocks with the lowest PEG ratios.  Chances are there are reasons that they are trading that low.  Be especially suspicious if a stock has traded sideways or down in a bull market.  If you went back to the banking stocks before the financial crisis started, it would appear that they were valued very well, with their average P/E based on future earnings in the ballpark of 8 to 10 times earnings.  However, earnings sank instead of the realizing the growth that investors’ expected.  If you took the actual earnings for the next year and applied them to the price before the financial crisis, the real P/E of banking stocks was actually closer to 80 than 10.

You should always take into account the quality of earnings forecasts when making selections.  When a company has to lower guidance, the higher PE stocks are almost always hit harder than low PE stocks. For that reason, you should give slightly more favor to lower PE stocks, assuming they have a similar PEG ratio to a higher PE stock.

Regarding the consistency and reliability of earnings, these are two factors that matter greatly in choosing stocks.  The longer the track record of sustainable and consistent earnings growth that a company has, the higher the valuation will grow.  These companies typically trade for a premium to other companies, but the premium is often worth the price.  That’s because companies that have trouble posting consistent earnings often anger and lose many of their investors over time.  However, companies that investors can feel confident in, and have a more likely chance of realizing their forecasts, make investors happy and will draw in new investors over the years.

There is a huge difference in how each company is run.  To find the best long term values, you must find reasonable valuations by using the likes of PE and PEG ratios, but more importantly, you must choose companies that are well run and offer superior products.

Stocks value stocks