How to Uncover Cheap Stocks

July 23, 2006

Tips to find attractively valued stocks using P/E ratios and market cap figures.

In past articles, I have used P/E numbers to arbitrarily conclude whether a stock is fundamentally overvalued or undervalued. Price to earnings ratios are an important factor when determining whether a stock is a worthwhile investment. There isn’t any single numerical ratio that can be used to make conclusions about a stocks valuation, since different industries have varying conventional ratios.

Market capitalization, or the present market value of the company, can also impact the likelihood of future share appreciation. Using these two measures, you can weed out weak stocks and find those with the greatest potential to outperform the overall market.

P/E ratios are calculated by dividing the current share price by the company’s earnings in the past year. Many financial websites also provide a forward P/E, which uses the same formula, but incorporates earnings estimates for the next year instead of past results. The current average P/E ratio of the S&P 500 index is about 18.4. When looking at individual stocks, it is important to compare it with the P/E ratios of its peers within the same sector.

Cyclical industries like steel and oil are trading in the P/E range of 8-12, as investors remain cautious about the health of these sectors in the event of an economic downturn. These cheap valuations make them very attractive; since there is a smaller premium to pay in order to own the company. In essence, your money is buying a chunk of a company that is closer in actual value to what you are paying. One region this cheapness often doesn’t apply to is the tech sector.

Technology issues have taken a severe hit in the past several months as earnings warnings and misses from companies cause investors to flee in the face of slowing growth. Already rich valuations and P/E ratios northwards of 40 provide extreme downside risk, which is currently being factored into tech stocks. The additional problem of backdated stock options place extra pressure on P/E ratios, as many tech companies’ earnings may not be as high as originally stated due to the scandal.

Investors should be on the lookout for battered stocks, who are pricing in worst case scenarios that are unlikely to play out. Panicked selling can often cause this to happen, and a simple analyst upgrade may be all that is needed for people to get back on board.

CONTINUED: A look at Google's valuation        <  1   2      >