How to Find Undervalued Stocks – Top 4 Stock Metrics You Need To Know

by Hank Coleman

How to Find Undervalued StocksDo you know how to find undervalued stocks? Do you have trouble finding which individual stocks you should target to buy? Many investors struggle with finding stocks are a good value that they should invest in. How do you wade through the thousands of companies and their stocks to find the diamond in the rough? Here are the top four simple stock metrics that you need to know when evaluating stocks to buy.

You can use a company’s Price To Earnings Ratio (P/E Ratio) in order to found out if it is cheap relative to the company’s peers and then subsequently how much the stock should be worth. A company’s dividend growth rate can help you to found out approximately how much its stock price can expect to grow. Growth rate can show if its stock price can command its high valuation. And, dividend yield can help point you in the right direction when looking for a stock to purchase.

How to Find Undervalued Stocks – Top 4 Stock Metrics

  • Price to Earnings Ratio
  • Growth Rate (PEG Ratio)
  • Dividend Growth Rate
  • Dividend Yield

Price To Earnings Ratio (P/E Ratio)

You will see Price To Earnings Ratio written several ways in the financial press and news organizations. Don’t be fooled. If they write it like P/E Ratio, PE Ratio, or simply spell it out they are talking about the same killer stock metric.

A company’s price to earnings ratio simply provides investors with a quick number to show how expensive a share of that company’s common stock is relative to the amount of profit that it makes. You find the ratio by taking the earnings that the company has earned either in the current period or earnings that have been forecasted in the future and divide the price of a share by that earnings number.

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Make sure that you are comparing apples to apples and not apples to oranges when you are making your calculations. For example, you can do your division either on a per share basis or on a total annual earnings amount for the year or quarter with the total number of common shares floating on the market. The most common way to find the calculation is on a per share basis.

So, for example, if a company has $100 million in annual profit and 50 million shares outstanding that are currently being traded amongst investors on the open market, then that company has a per share profit of $2 ($100 mil / 50 mil shares).

If that same company’s stock currently traded for $30 per share, then the Price To Earnings Ratio (P/E Ratio) would be 15. You arrive at that number by dividing the price ($30) by the per share earnings ($2). Pretty simple, right?

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How P/E Ratios Help You Find Cheap Stocks

One of the simplest ways to find a cheap stock using this killer stock characteristic, P/E Ratios is by comparing a company and its peers in its industry. To kind of give you an example, there are 11 sectors that comprise the Standard and Poor’s 500 Index (S&P 500) and the overall US economy. And, you can break those sectors down into more specific industries. Often, when you compare companies in its industry with its peers, you can find hidden gems of stocks that are undervalued.


P/E Ratios Help You Find Cheap Stocks
You may find that an industry leader is commanding 19 times earnings for its share price while a very similar stock you are targeting is currently priced at 17 times earnings. This may be an indication that the stock could appreciate by approximately 10% in the future to mirror its rival’s stock price and the P/E Ratio they command.

Of course, this isn’t the only stock metric you should be using to evaluate the stock’s potential. They may be some other reason for the stock’s low P/E Ratio. 

Simple Stock Valuation Method Using The P/E Ratio

Using my favorite company, Dr. Pepper Snapple Group (Stock Symbol: DPS) and its industry rivals, you can find a quick calculation as to what a potentially fair price for the stock could be relative to its peers. Dr. Pepper is currently trading at a P/E Ratio of 19.8. Coca-Cola (KO) trades at P/E Ratio of 24. Pepsi Co. is just over 23.

Even if the industry average is closer to Pepsi’s range, you can view Dr. Pepper as undervalued when compared to its peers. A P/E Ratio of 24 would imply a valuation of Dr. Pepper stock at $105 and a P/E Ratio of 23, like Pepsi, would put the stock over $100, a 14% increase from its current share price.

Dividend Growth Rate

Another great metric when learning how to find undervalued stocks is the dividend growth rate. I love dividend paying stocks. They pay you to wait for their share prices to grow with dividends. A company’s dividend growth rate is a good proxy for how much their share price should also grow.

A company’s share price is the present value of all its future cash flows (dividends) according to classic finance theory. So, a simple way to look at it is that a company who is increasing its dividends by 3% to 5% each year should see its share price of its common stock growing at approximately the same rate.

To give you an example, Coca-Cola (Stock Symbol: KO). In 2002, the Coca-Cola company issued a quarterly dividend of 20 cents or 80 cents per year. The share price of Coke at that time was right at about $50. Over the next ten years, Coca-Cola’s dividend has increased to 51 cents per quarters or $2.04 per year by 2012 before having a 2-1 stock split in 2012. That is a 10% annual increase in their dividend.

Coca-Cola’s dividend is currently 35 cents per quarter or $1.40 per year. When you adjust for the 2-1 stock split, that would have equated to $2.80 in 2002 dollars, which is over a 12% annual increase in the dividend. 

Currently, Coca-Cola’s stock price has risen to $41.81 this year. That actually equates to only a 3.5% annual rise in the price of their stock. Of course, that rise hasn’t been on a straight line but ebbs and flows with the macro economy as well.

Stock Valuation Method Using The Dividend Discount Model

The formula for the dividend discount model

The dividend discount model values the price of a company’s stock by using predicted future dividends and discounting them back to present value and including their growth rate and the expected return as well. The model uses the variables of the company’s dividend growth rate in perpetuity, the cost of equity or required rate of return, and the dividend price in order to determine what the stock’s current share price should be.

To continue with the earlier example of Coca-Cola, you can find its share price by plugging in certain inputs into the dividend discount model’s formula. Coke’s dividend is $1.40, its dividend growth rate is 10%, and you can plug in a required rate of return of 12% into the formula. Using those inputs, you could expect Coca-Cola’s share price to be worth $70 ($1.40 / 12% – 10%).

Company Growth Rate

Another great metric when learning how to find undervalued stocks is it’s growth rate. Just because a company has a high P/E Ratio does not mean that you should completely write it off as a good value.

One reason that a company may be able to justify a high price for the shares of their common stock is their incredible growth rate. We have seen this time and time again with many technology stocks that see fast growth especially in the initial stages of growth.

One reason that a company may be able to justify a high price for the shares of their common stock is their incredible growth rate. We have seen this time and time again with many technology stocks that see fast growth especially in the initial stages of growth.

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Why would you pay more for a faster growing company?

Like I have mentioned many times before, the classic finance theory on stock prices revolves around future earnings. A stock’s current price is the present value of all the company’s future cash flows (earnings). When a stock is growing, it is of course assumed that the growth will translate into higher earnings in the future.

How The PEG Ratio Help You Find Fairly Priced Stocks

The Price/Earnings to Growth Ratio, also known simply as the PEG Ratio, is a great tool that is used to determine whether a stock is potentially under or overvalued. The PEG Ratio is very similar, of course, to the P/E Ratio with its closely related calculations. But, PEG takes into account a company’s growth rate.

Simple Stock Valuation Method Using The PEG Ratio

PEG Ratio formulaA lower PEG typically means that the stock’s share price is a good value relative to other companies who have similar profits and growth rates. Usually, any PEG Ratio that is under 1.0 is considered undervalued.

Anything over 1.0 is overvalued based on the amount of growth that the company is experiencing. So, for example, Apple Inc. (Stock Symbol: AAPL) price to earnings ratio per share (P/E Ratio) is 13.87, and Apple’s annual growth rate is 69.7%. That makes its PEG Ratio 0.19 which would typically indicate that the stock is growing faster

How Do You Find A Company’s Growth Rate?

A key question that you may be wondering is how to find a company’s growth rate so you can calculate its PEG Ratio? You have to dig a little deeper on most stocks to find the answer. 

Investors can find the growth rate given by the company is press releases or other financial filings. You can also determine it yourself, but you must be sure that you are looking at data for one year and forecasted in the future.

Dividend Yield

I love stocks that give dividends to investors. I often prefer to buy stocks that offer a dividend yield as opposed to regular stock. Of course, choosing dividend payers is a personal preference, but dividend paying companies typically make great investments.

Reasons To Consider Dividend Paying Stocks

Dividend Payers Are Profitable. Most companies only issue dividends when they are earning a profit. In fact, if a company is issuing a dividend without a profit, you should run and not walk to the exit. Profitable companies issue dividends and even more profitable ones increase their dividends over time.

Dividend Payers Are Older And Wiser. Dividend paying companies are typically safer and more established than other companies that do not issue dividends. It typically takes companies years to issue its first dividend. Just look at Apple Computers for example. It took them decades to issue one to investors.

Dividend Stocks Pay You To Wait. Dividend paying stocks pay investors to wait for the company’s stock price to increase. Even if they are good shares in good companies but their share prices have stalled, you can still earn money while waiting on the company’s stock price to rebound.

Companies That Offer A Dividend Are Few. If you are finding it difficult to find great companies to invest in, choosing a dividend payer may be a great place to start simply because it will narrow your choices considerably.

What Is Dividend Yield?

Dividend yield is a measure of the amount of cash flow you will receive from your investment. Dividend yield is typically measured as a percentage of your total investment.

To give you an example of how to calculate dividend yield, let’s say that your stock investment pays annual dividends of $1 per share and you bought it for $20 per share. That means that your stock’s dividend yield is 5% ($1 / $20).

One of the bad things though about the share price of your stock going up is that your dividend yield will drop. This is typically because the company’s dividend that it issues will not change as much as its share price might. If the stock price doubles to $40 per share, your dividend yield will drop to 2.5% ($1 / $40). The dividend itself hasn’t changed, but the share price and dividend yield sure have.

Too Much Dividend Yield May Be Bad Too

This very same dividend yield problem can have a similar and negative aspect if the share price drops too much. You should not simply look for a stock with the highest yield. If a share price drops like a rock but the company still issues its same dividend, the yield will rise incredibly.

This can be a serious red flag to investors. A share price that dropped to $10 per share but still issues $1 annual dividend will result in a 10% dividend yield. So, a juicy dividend yield does not always indicate a great stock. Be sure to find out why the yield is so great.

Why Look For Stocks With Good Dividend Yield

Dividends provide compounding interest if you reinvest your dividends back into new shares of stock. When you get a dividend and immediately have the company or your stock brokerage firm reinvests it for you, you purchase additional shares of the stock.

Then, you will receive even more dividends during the next quarter when the next round of dividends is issued. And, like compounding interest on your bank account, your dividends will earn their own dividends compounding over and over.

Do you know how to find undervalued stocks? Are you like me having trouble finding the best individual stocks to invest in? I am constantly struggling to find the best stocks with a good value to invest in. How do you wade through the thousands of companies and their stocks to find the diamond in the rough? 

Do you know how to find undervalued stocks? Which stock metrics do you look for when evaluating stocks to buy? I’d love to hear your tips in the comment section below.

How to Find Undervalued Stocks

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About Hank Coleman

Hank Coleman is the founder of Money Q&A, an Iraq combat veteran, a Dr. Pepper addict, and a self-proclaimed investing junkie. He has written extensively for many nationally known financial websites and publications. Hank holds a Master’s Degree in Finance and a graduate certificate in personal financial planning. Email him directly at Hank[at]MoneyQandA.com.


Hank Coleman has written 582 articles on Money Q&A. Learn more about Money Q&A on Twitter @MoneyQandA and @HankColeman.


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{ 8 comments… read them below or add one }

Paul @ The Frugal Toad

Great idea for a series Hank! PE is a great place to start when looking at a stock and comparing to it’s peers and the overall sector can give you some insight as to whether the stock warrants further research. However, stocks usually trade at a discount for a reason that is not always know to the general public.

Reply

Hank Coleman

Paul – You are definitely right about other factors that feed into the valuations and why certain stocks may trade at a discount. P/E Ratio is a good starting point and will lead to further investigation to try and determine valuation.

Reply

Get Rich Point

PE ratio is a great criteria to judge the stocks. I first came to know about it from ” One Up on Wall Street.

Reply

Hank Coleman

It is definitely a good starting point.

Reply

Worli

Lots of investors base their valuation and buy or sell decision of a stock based on the P/E ratio. Yet, this must only be used as one of the many other indicators to help value a stock. If these are the sole criteria for investment decisions, then it is very probable that it may lead to a bad investment.

Reply

Constructaquote

This is the First time i came across this formula, I will give it a go my self, Thanks Hank.

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Jai Catalano

Nice I learned something new. Once you are done with this series please write a post with all of them together. Sorry to jump the stock (gun) but I want a quick reference guide when I come back.

Reply

GoodTrader

Price trends and market sentiment are the key factors for success in the stock market. In a bull market fundamentals are important but in a bear market, fundamentals do not hold the asset price.

Reply

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