One of the simplest investment strategies of legendary investor Warren Buffett is to “be fearful when others are greedy and to be greedy only when others are fearful.” Simplified further, it would imply “buy low and sell high.”
Investors therefore need to figure out strategies or indicators that can help them identify cheap stocks. Be it top-down analysis or bottom-up analysis to find stocks — it ultimately boils down to valuation ratios.
Some relatively complex methods to value companies include the discounted cash flow model and Gordon Growth model. However, there are simple, yet effective methods, to find and invest in cheap stocks.
One of the most commonly used valuation ratios is the price-earnings ratio. In simple terms, the ratio gives the dollars investors are willing to pay in the market for every dollar of the company’s earnings.
Simple, no doubt, but if investors have few tricks up their sleeves, the P/E ratio can help in finding value creators. This column will discuss three tricks that can help investors use the valuation ratio to find undervalued stocks.
Price-Earnings Ratio Combined with Price-Earnings-Growth Ratio
A general view is that stocks with a low P/E are undervalued and stocks with a high P/E are overvalued. However, this is nothing more than a myth.
The P/E ratio varies from industry to industry. More importantly, a low P/E might indicate that the stock is not favored by the market. A high P/E can be a result of investors willing to buy an attractive business even at a premium.
So how do we draw a line?
The answer is in looking at the PEG ratio in combination with the P/E ratio.
Let’s understand the concept with the help of a simple example. For example, in October 2020, JD.com (NASDAQ:JD) traded at a P/E of 50.7. On a standalone basis, this valuation appeared stretched. However, analyst estimates indicated that the company’s annual earnings growth would likely grow at 49.7% over the next five years.
Therefore, the PEG ratio (P/E divided by growth) is just 1.02. This indicates that the stock is not overvalued. The PEG of other companies in the industry can be calculated to determine the relative attractiveness.
Overall, the PEG ratio helps in finding cheap stocks that can potentially double. Just to add, I believe that JD stock can double from current levels in the next few years.
Getting Into the Habit Of Using Forward P/E
A very simple fact about the market is that the stocks discount the future in valuation multiples. Therefore, if investors look at the current P/E, it does not make sense from a valuation perspective. Forward P/E matters more than current P/E.
As a general rule, if the current P/E is high and the forward P/E is low, the stock is attractive. On the other hand, if the current P/E is low and the forward P/E is high, investors need to avoid the stock.
In addition, if the forward P/E is indicating that the stock is cheap, investors can further confirm by looking at the average industry P/E through business cycles. If the forward P/E is lower than the average industry P/E, the stock is cheap and up for grabs.
Let me explain this further with the help of an example. Zoom Video Communications (NASDAQ:ZM) stock skyrocketed by 525% from October 2019 through October 2020. The stock sported a trailing-twelve-month P/E of 614.9 at the end of that rally. Many investors might not look further as, seemingly, the stock is in a bubble.
However, ZM stock traded hands at a one-year forward P/E of 191.3. Clearly, the forward P/E tells a different story. The company is in a high growth trajectory and the stock discounted the future. Even a small correction in the stock would be a good entry opportunity. Again, the forward P/E needs to be compared with the industry average. This will help in finding value.
This also underscores my view that a cheap stock is not necessarily one with a low P/E. Investors kept talking about Tesla (NASDAQ:TSLA) stock being expensive through the last year. During this period, the stock went ballistic and surged by 795%.
Screening Low P/E Stocks for Potential ‘Doublers’
As a general rule, low P/E stocks do not imply cheap stocks. However, a low P/E stock can also be a cheap stock that has the potential to double. Therefore, investors need to use a screener to identify low P/E stocks and investigate further to pick value creators.
I use the following benchmark to screen low P/E stocks – The S&P 500 index traded at a P/E ratio of 29.3 as of October 2020. Stocks that are trading at a P/E that’s significantly below the index P/E are worth investigating.
The reason is not fundamentals or a weak business model. The novel coronavirus pandemic has impacted automobile sales. Further, the company is in a period of transition with focus on electric vehicles.
For me, GM stock is a cheap stock that can potentially double in the next few years.
The key learning: Investors should apply a P/E screener and look for fundamentally strong names that are trading at a low P/E due to industry headwinds. Cyclical stocks, for instance, can witness sharp swings in P/E ratio. Having a broad awareness on the economy can help you to identify cyclical stocks with a low P/E.
On the date of publication, Faisal Humayun did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Faisal Humayun is a senior research analyst with 12 years of industry experience in the field of credit research, equity research and financial modeling. Faisal has authored over 1,500 stock specific articles with focus on the technology, energy and commodities sector. As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.