There are many different types of investors: some focus on growth stocks, while others prefer dividend-paying stocks, and some seek value.
Value investors look for stocks that are trading at a price below their intrinsic (or true) value. By finding companies whose stock price doesn’t reflect their business or financials (like revenue and earnings), value investors hope to capitalize on a broader market that undervalues certain stocks. In other words, if the true value of a company is $100 per share and it is trading at $80, value investors will invest, hoping that the market will eventually price it correctly at $100. $ and they will make money (a gain of 25%).
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Investors should be careful not to confuse a cheap stock with a value stock, as this could be costly. It could very well be that a $1,000 stock is undervalued and a $3 stock is overvalued. You always want to avoid a value trap, which is a stock that looks cheap but isn’t. You would regret buying a lot of stocks because they are cheap, but it turns out that you are investing in a struggling or stagnant company.
Using the P/E Ratio to Find Undervalued Stocks
A great way to tell if a stock is undervalued or overvalued is to look at the price-to-earnings (P/E) ratio, which tells you how much you’re paying for every dollar of company earnings. You can find a company’s P/E ratio by dividing its current stock price by its earnings per share (EPS). For example, if a stock is worth $100 and has EPS of $4, its P/E ratio would be 25, which means you pay $25 for every $1 in earnings.
You can’t look at the P/E ratio by itself to determine if a stock is undervalued; you need to compare it to similar companies within its industry. You wouldn’t compare Apple (NASDAQ:AAPL) at ExxonMobil (NYSE: XOM) Where Bank of America (NYSE: BAC) at You’re here (NASDAQ: TSLA)but you can compare Apple to Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG) or Bank of America for Wells Fargo (NYSE: WFC).
If you look at a company’s P/E ratio and it is significantly lower than other companies in its industry, that could be a sign that it is undervalued. The reverse is also true. If a company’s P/E ratio is in the 20s while others in its industry are in the single digits, it is likely overvalued.
Finding value stocks isn’t so simple
You’d be hard pressed to find anyone who doesn’t like a good discount – it’s what makes value investing appealing to many people. But if value investing were simple, everyone would find value stocks and make good investments. Unfortunately, it is not the case.
Value investing takes time and research. After all, you don’t know if a stock is undervalued just by looking at its price; you need to research the company itself and compare it to similar companies to make this decision.
Value investing is a great way to minimize some of your risk and increase your chances of good returns, but it takes time to become a successful value investor. If you’re willing to put in the effort, it can pay off big time.
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Bank of America is an advertising partner of The Ascent, a Motley Fool company. Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. Suzanne Frey, an executive at Alphabet, is a board member of The Motley Fool. Stefon Walters holds positions at Apple. The Motley Fool has positions and recommends Alphabet (A shares), Alphabet (C shares), Apple and Tesla. The Motley Fool recommends the following options: long calls $120 in March 2023 on Apple and short calls $130 in March 2023 on Apple. The Motley Fool has a disclosure policy.