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How to identify undervalued
stocks or overvalued
stocks
As for
"the criteria/methodology" for undervalued
stock, the general rule is to discern the intrinsic value of the Company
and compare it to its enterprise value. For enterprise value, it's the sum of
the market value of equity plus the market value of the debt less surplus cash.
You want to buy the stock when it's current market value is trading at
a deep discount to the intrinsic value. As for intrinsic value, you might need
to perform a discount cash flow (DCF)
Analysis, a replacement value analysis (how much money it would take creates
the current company today), etc.
As for
the "things we need to look at to evaluate," you need to understand how the firm
makes money, how it generates free cash flow, what it's return on invested
capital is, etc. In order to understand the firm, you need to understand the
industry, how the company fits
in within the industry, where is the industry and company going in the future,
etc.
To
simplify the task of identifying undervalued stocks, there are several simplified
criteria that can be used and are readily
available on the internet. These are PE ratio, PEG ratio, ROE, PS ratio, DE
ratio, dividend, and historic data. Generally speaking stocks with lower PE
ratios (price divided by earnings ratio) are more likely to be undervalued than
those with higher PE ratios. The cut off is somewhere in the range to 12 to 16.
That does not mean that a stock with
a PE ratio of 20 is necessarily overvalued but
it does mean that it might be. Also a stock with a PE ratio of 10 may not be
undervalued. That is where the PEG ratio comes into play. This is the PE ratio
divided by the expected growth rate.
A PEG
ratio of less than 1.00 is considered likely undervalued. A PEG ratio of more
than 2.00 is most like overvalued. The problem with the PEG ratio is
ascertaining the projected growth rate. You can find published PEG ratios on the
internet for many companies, but unfortunately the projected growth rates upon
which they are figured are normally concocted by overly optimistic security
analysts, so taking them with a pound of salt is called for. DE ratio (debt to
equity ratio) is also a helpful indicator.
The
higher this ratio the more leveraged the company is and the higher the interest
payments are. A high DE ratio many times
is correlated with a low PE ratio because the quality of the earnings is less
and the ability of the company to weather a downturn is less. The airlines were
good examples of this. They were all highly leveraged and they all went bankrupt
as a result when they could not meet their interest payments.
ROE
(return on equity) is an indicator of how profitable the company is. More
profitable companies are generally valued more highly than less profitable
companies. Historical comparisons can also be a significant indicator of the
value of a company. All other things being equal if the company in the past sold
at a PE ratio of 17 and it is now selling at a PE ratio of 13, it might be
undervalued. It also might be the result of lower future expectations for the
company such as we are seeing in the market today.
Please keep in mind that stocks can remain undervalued and
overvalued for long periods of time, so invest wisely.
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