Buying cheap shares is one of the best ways to get an edge in the stock market. In fact, one school of thought views undervalued stocks as the only way to get market-beating returns.
But in scouting for these underpriced assets, a lot of investors fall into a simple trap and buy shares that aren’t as cheap as they first appear.
Let’s look at how to avoid this common pitfall – and how I’m targeting shares below their true value as the market remains cautious.
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The price-to-earnings ratio is one problem. The P/E ratio is a simple and popular tool. At a glance, I can use this measure to tell me the cost of a stock relative to its profits.
Solid strategy
Investors love the simplicity of the P/E, but it’s a long way from a solid strategy to reveal undervalued shares.
Take Vodafone for instance. The telecoms giant trades at a whisker over two times earnings. Is a P/E of 2 a good deal? Well, it might be. But the firm’s bottom line was propped up by a €9 billion disposal this year. These one-off earnings make the stock look cheaper than it is.
Lloyds is another useful example. The black horse bank has a P/E of just 6.1 right now. Time to log in to my brokerage account with pound signs in my eyes? Not yet. In Lloyds’ case, I’d want to compare the bank’s earnings to its competitors in the UK and abroad.
The lesson here is: if I truly want higher-than-average returns from my investments, I must explore beyond the surface level. So what are some ways to dig deeper and assess a company’s true value?
For growth companies, the price-to-earnings-to-growth (PEG) ratio is a common tool. This ratio was popularised by fund manager Peter Lynch who is famous for searching for 10-baggers – stocks that rise in value 10 times over.
A better way?
The ratio combines share price and earnings with the growth in earnings to give a quick valuation. A value of one is considered fair and below one undervalued.
For example, Tesla has a PEG of 1.77 right now, which Lynch might say is on the pricey side according to his metric.
For established companies, a discounted cash flow (DCF) model might be more appropriate. A DCF examines the share price compared to the amount of cash the company will make in the years ahead.
For companies with predictable earnings, a DCF analysis aims to reveal how much safety is built into a share price.
With UK share prices seemingly at a low ebb, the New Year might be a great time to use these tools to discover stocks below their true value. I’ll continue hunting for cheap shares where I can.
