3 Metrics Profits Use to Find Great Unquoted Stocks
For most investors, a well-diversified portfolio will do the trick. But if you want to try to identify winners like the pros on Wall Street, there are steps you can take.
Professional investors look at several metrics to determine if a stock is undervalued (though remember that metrics alone don’t always tell the whole story). Here are three metrics you can check.
1. Price-to-earnings ratio
The price-to-earnings ratio, or P/E ratio, shows the price of a company’s stock in relation to its earnings per share. Undervalued stocks are generally undervalued relative to the company’s earnings.
The ratio is calculated by dividing the stock price by the earnings per share. For example, a stock worth $100 with annual earnings of $5 per share has a P/E ratio of 20. The 20 P/E ratio doesn’t tell you much, but combining it with more context will reveal if the 20 P/E ratio is large or profitable.
Investors can compare a stock’s P/E ratio and its historical figures to determine whether it is a good buy. A stock trading at a 20 P/E ratio may be a good buying opportunity if historically it has maintained a 25 P/E ratio, as it is now considered cheap. You can also look at the P/E ratios of competitors. For example, if one bank has a P/E ratio of 10 and another bank has a P/E ratio of 15, the bank with a P/E ratio of 10 looks undervalued, assuming that both banks are growing at the same rate.
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2. Debt-to-equity ratio
The debt-to-equity ratio is an indicator of a company’s financial health because it shows how much the company relies on debt. A high ratio can indicate that a company is heavily reliant on debt, and tends to indicate risk. The debt-to-equity ratio is calculated by dividing total debt by total stockholders’ equity.
A good debt-to-equity ratio depends on the industry, but many consider a solid ratio to be less than 1.50.
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3. Restore balance
Return on equity measures how a company can turn shareholder capital into revenue growth. A high return on equity is a good sign and indicates that the company is able to generate a good return on investment (ROI) from the money it receives from investors.
Return on equity is calculated by dividing the company’s net income by the number of average shareholders. The positive return on equity depends on the industry, and it is wise to compare the ROEs of many companies.
A high return on equity can be a telltale sign of a good management team, and all that extra return can be reinvested in the business. These reinvestments can compound profits and translate into higher returns.
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