Understanding Undervalued vs Overvalued–Learning from STT

Understanding Undervalued vs Overvalued--Learning from STT

 

One of the most important considerations when investing in stocks is whether a company’s shares are undervalued or overvalued. Investors, particularly for longer-term investments, want to know whether a stock is trading below or above its true, or fair, value.

There are a many different approaches used by investors to determine this, and most rely on more than one metric to spot undervalued stocks that might be a great opportunity. Calculating market price against earnings, or earnings growth expectations, return on equity, debt-to-equity ratios…and the list goes on.

Sometimes a company’s management is taking actions with the firm’s shares, such as share repurchases or share issues, which you can also use as a hint of what the company’s leaders and CFOs think about the stock being undervalued or overvalued.

It’s not something you’ll learn overnight.

This is exactly why, at stockstotrade.com, we’re about to embark on an educational series featuring at least 2 new technical indicators each week. We’ll explain each indicator in language that everyone can understand. We’ll tell you why each indicator is so important, and then we’ll take it one step further: We’ll show you, step by step, how to use that indicator on stockstotrade.com. 

But at STT, we’re not going to just teach you about metrics that help you decide whether a company is overvalued or undervalued—that’s investing. We’re going to teach you about technical indicators for TRADERS that can forewarn you about shifts in momentum with a stock, irrespective of how a company the doing fundamentally.

Before we begin our technical indicator series, which will focus more on trading than investing, we will take a brief look at one of the equations investors use to calculate whether a stock is under- or overvalued: the PEG ratio.

PEG = Price/Earnings ÷ Growth of Earnings

This PEG ratio approach to peg the value of a stock is calculated by dividing the price-to-earnings (P/E) ratio by the projected growth rate over a certain period of time. The first part of the equation — P/E — in turn, is reached by dividing the stock’s current share price by its annual earnings per share (EPS). The earnings growth part of the equation is the percentage of growth that analysts following the company expect.

 

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Generally, a PEG ratio below 1.0 would mean that a stock is undervalued, while a PEG ratio of more than 1.0 would point to the assumption that a stock is overvalued. The PEG ratio hitting exactly 1.0 would mean that the stock is trading at its fair value. So, the lower the PEG ratio, the more a stock may be undervalued compared to its earnings performance. 

The PEG ratio may also point to other assumptions for a stock. For example, if the PEG ratio is higher than 1.0, it could also mean that the market expectation of growth is higher than the analyst consensus estimates. Or, if the PEG ratio is below 1.0, the market could be underestimating the potential growth of the stock, or the consensus estimates could be too low at present.  

Apart from using various kinds of ratios to determine if a stock is undervalued or overvalued, you can also follow company moves such as share repurchases to assess what the management thinks of the company’s shares.

A share repurchase is often launched when the management believes that the shares are undervalued, and reduces the number of shares. A company can choose to buy shares directly from the market or offer shareholders the option to tender their shares directly to the company at a fixed price. Since a share repurchase reduces the number of shares outstanding, such a program increases EPS as well as the market value of the remaining shares.

Another sign you may want to look for is insider purchase activity — when senior managers of a company use their own money to buy the company’s stock. Generally, senior management and directors buying their company’s shares points to favorable prospects for the company and the management’s belief that the shares would trade higher in the future.

In case the managers think that the company’s shares are overvalued, they could issue more shares that will result in more shares on the market, raising money via an equity sale in the process.

Before jumping to buy/sell stocks based on PEG ratio and share repurchases/issues, you’d probably first want to consider if the particular industry is cyclical and whether it depends on economic growth or downturns. Is your stock in the consumer goods sector? Or is it closely connected and/or dependent on the price of a commodity, and would it need further insights into the price of copper in Australia or Chinese demand for oil?

Another thing to consider in a stock is also the debt-to-capital ratio, calculated by taking the company’s debt and dividing it by the total capital. Total capital, in turn, is all debt plus shareholders’ equity. Generally, the higher the debt-to-capital ratio, the more debt is being used to grow a company’s business. The lower the ratio, the more strategically debt is employed, and the business is growing organically.

Before you begin calculating if a stock is undervalued or overvalued, consider first the state of its industry, then see if that stock fits your investment strategy, financial goals, and your risk tolerance.

This is simply a preview of some of the metrics and indicators we will be covering and dissecting for you, in-depth, over the course of the coming weeks and months—so stay tuned to STT.

 

Check out STT’s new Twitter Streams! One of our most important new releases of 2017 is the inclusion of Twitter as a source of data for keeping up to date with the latest social discussions on a given stock. Every Stock tab includes a Twitter data feed which focuses only on tweets mentioning the company being tracked.

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