If you’re trying to find undervalued stocks to trade, chances are you’ll need to understand some fundamentals. Although we’re primarily focused on technical patterns and catalyst events, we don’t completely ignore other pertinent information. Now, it pays to know about key fundamental ratios, especially if you’re trying to find undervalued stocks. That said, let’s take a look at how to find value in the stock market.
Undervalued Stocks – Price/Earnings to Growth Ratio
The P/E ratio is one of the most commonly used fundamental metrics used when valuing stocks. Now, just like any other indicator, the P/E ratio may not be the be all and end all. For example, the P/E ratio does not take into account forward earnings. Especially when a company provides guidance, it helps to take into account the growth rate projection for its EPS.
However, that’s one of the problems with the P/E ratio.
This is where the price-to-earnings-growth ratio (PEG ratio) comes in to play.
Basically, all you have to do is take the P/E ratio and divide it by the projected earnings growth rate. Generally, a PEG ratio less than 1 indicates that a stock could be undervalued. On the other hand, a stock with a PEG ratio greater than 1 could indicate a stock is too expensive. There’s one thing to keep in mind when comparing valuation ratios: only compare stocks in the same industry. It doesn’t really make sense to try to find undervalued stocks if you’re comparing stocks in different industries.
Now, let’s see how you can use the PEG ratio along with the P/E ratio to potentially find undervalued stocks.
Undervalued Stocks: PEG Ratio Example
Now, let’s assume you’re looking to find undervalued stocks in the financial industry. One stock trades at 15 times its earnings, while the second trades at 20 times earnings. At first, you might think that the first stock is undervalued and may be a more attractive investment. However, let’s say both of the companies provide guidance. The first stock forecasts its earnings to grow by 5% over the next year. On the other hand, the second company projects its earnings per share to grow at 18% over the next year.
Consequently, the first stock has a PEG ratio of 3, while the second stock has a PEG ratio of 1.11. Consequently, the second stock could be considered undervalued.
Undervalued Stocks: Filtering for Stocks with Low PEG Ratios
Now, when you’re trying to find undervalued stocks, it could be difficult to find stocks to trade. Therefore, you’ll need a good filter. Let’s assume we only trade large- and mega-cap stocks. You can filter for stocks with P/E ratios less than 15 and PEG ratios less than 1. This is a good starting point to potentially find undervalued stocks.
Here’s a look at this filter using Finviz.
So now you have 56 stocks to go through. You could incorporate chart patterns with these filters. For example, let’s assume you want to find stocks that have bottomed out and could potentially reverse.
We added the double bottom pattern here.
You could delve deeper into these companies if you know how to analyze fundamentals. Or you could use moving average crossovers along with these fundamental ratios to potentially find undervalued stocks.
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Finding undervalued stocks could be difficult at first. You can’t rely solely on one fundamental ratio. You need to combine other ratios for confirmation. Moreover, you need to only compare companies within the same ratio. Some traders may also find it useful to combine fundamentals and technicals to find undervalued stocks. Remember, trading is an art form, not a science. You need to learn how to use these ratios and technicals properly before putting real money on the line.