Professional investors look at several metrics to determine if a stock is undervalued (though keep in mind that metrics alone don’t always tell the whole story). Here are three metrics you can assess.
1. Price-to-earnings ratio
The price-to-earnings ratio, or P/E ratio, shows a company’s stock price relative to its earnings per share. Undervalued stocks typically have a low price relative to how much money the company is earning.
The ratio calculated by dividing the stock price by the earnings per share. For instance, a stock worth $100 that has an annual $5 earnings per share has a 20 P/E ratio. A 20 P/E ratio doesn’t tell you much, but combining it with additional context will reveal if a 20 P/E ratio is excessive or a bargain.
Investors can compare a stock’s P/E ratio with its historical valuation to determine if it’s a good buy. A stock trading at a 20 P/E ratio may be a good buying opportunity if it has historically maintained a 25 P/E ratio, since it’s now considered cheaper. You can also look at the P/E ratios of competitors. For instance, if one bank has a 10 P/E ratio and another bank has a 15 P/E ratio, the bank with the 10 P/E ratio looks more undervalued, assuming both banks are growing at the same rate.
2. Debt-to-equity ratio
A stock’s debt-to-equity ratio is a signal of a company’s financial health because it shows how much a company relies on debt. A high ratio could show that a company relies heavily on borrowed money, and tends to indicate risk. The debt-to-equity ratio is calculated by dividing total liabilities by total shareholders’ equity.
A good debt-to-equity ratio depends on the industry, but many consider a solid ratio to be below 1.50.
3. Return on equity
Return on equity measures how effectively a company can turn shareholder capital into revenue growth. A high return on equity is a good sign and indicates that a company knows how to generate a positive return on investment (ROI) from the money it receives from investors.
Return on equity is calculated by dividing a company’s net income by the average shareholders’ equity. A good return on equity depends on the industry, and it’s smart to compare multiple companies’ ROEs.
A high return on equity can be a telltale sign of a good management team, and all of those extra returns can be reinvested into the business. These reinvestments can compound profits and translate into higher returns.