How to know if stocks are undervalued or overvalued and how to know if a stock is expensive or cheap? How to compute the fair value of a stock?
I get this question so many times from readers and followers on Facebook and Instagram and I send them some answers but I tell them I need to say more but I can’t type that long in chat so I decided to post it here.
I think it’s much more convenient to just share my answers here.
My answers here are based from my personal approach as a passive INVESTOR and not as an active trader.
I prefer to go on the investing route because it’s simple and it’s not too technical for me. I’ve been investing for 6 years now and I enjoy doing this method.
Surprisingly, I had no stress about it ever. My money is growing, I get dividends and I learn a lot.
I just invest my money to my chosen stocks regularly. I double the shares I buy when the market is down; when it’s up, I buy anyway.
I plan to do this until I reached my target period then buy an apartment in Central Park, live a girlboss life in New York with my soulmate. Hahaha Sounds like a great plan but I like Europe better. A woman can dream 🙂
As always, I want to remind beginners to study first about investing. Don’t get too excited. Head on to our Stock Market Beginners Guide.
The market will wait for you. Take your time to study and understand what you’re getting into. Then, invest and apply what you have learned.
How to Know If Stocks are Undervalued or Overvalued?
There are thousands of methods used by analysts, professionals, bankers, brokers, fund managers and investors to determine the intrinsic value of a stock.
The truth is there is no exact formula to determine the exact value of a stock because there are millions of factors to be considered before you generate the exact amount of its value.
Like the future value of the company, the economy today, inflation, risks, etc.
That is why the MARKET is there and there are buyers and sellers.
If there is an exact valuation of a stock, no one’s gonna buy or sell it if the offer is way beyond the exact valuation.
So what do we do?
We use some metrics to figure it out and generate a close estimate in deciding whether it’s fair to buy or not.
The most common metrics used by investors are listed below. We use them here in Dailypik as well.
Note: You should use as many methods as possible because the more methods you use, the better in determining if a stock is cheap or expensive.
Price-Earnings Ratio (P/E)
This is the Price per Share of a stock divided by the Earnings Per Share (EPS).
We usually use the 12-months earnings. The P/E is usually available when you check out a company’s snapshot and statistics at some financial hub like Bloomberg, Yahoo Finance, Wall Street Journal and Philippine Stock Exchange.
- MBT Stock Price = 81.60
- EPS = 5.65
- P/E = 14.45
For me, the lower the P/E, the better. In this case, MBT is fair to buy from that given example so I should include it among my options to buy.
Book Value represents what would be left in the company if it suddenly went out of business.
You’ll get this figure by taking (Total Assets-Intangible Assets) – Liabilities. P/B of 1 or less is considered undervalued although not on some cases.
We use a growth expectation factor in deriving this ratio. In this method, we use P/E divided by Annual Earnings Per Share Growth.
When the result is less than 1, some analysts considered it as undervalued. Otherwise, overvalued if more than 1.
It’s simply price of the stock divided by revenue for the year. In most cases, the lower the P/S ratio, the cheaper the stock. The higher the P/S, the more expensive it is.
- BDO has 3.7444 Price to Sales ratio right now. Though it has a high P/E, it’s still attractive to invest it as it’s not much expensive
Price to Dividend ratio would tell you how much you have to pay to receive P1 in dividend payments.
This is not mostly used though but I included it here since I personally use it as a factor when choosing my stock picks. Besides, I like receiving dividends. Some investors also use the Dividend Yield.
Enterprise Value-Sales (EV/S)
EV is calculated by taking the Market Cap plus total debt (including preferred shares and minority interest) less cash and cash equivalents.
- JFC has EV/S 2.19. It is still attractive to invest JFC for its impressive revenue and future potential.
Enterprise Value-EBITDA (EV/EBITDA)
Simple EV divided by EBITDA. EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization.
Sounds geeky I know, those accounting terms. But thank goodness, we can check out these values even without using our calculators.
- Again, JFC has EV/EBITDA 24.84. Considering factors like market cap, debt, cash and EBITDA, it’s still attractive to invest in such company like JFC.
Discounted Cash Flow Model
This tells us that the value of money at present doesn’t have the same value with the money in the past and the future.
We have to consider different factors like time, inflation, risk and interest rate. This method apparently tells what the company is worth today.
Luckily, many brokers use this method as well. We can rely on the data they share.
- DCF = [CF1 / (1+r)1] + [CF2 / (1+r)2] + … + [CFn / (1+r)n]
- CF = Cash Flow
- r= discount rate
So those are the most common metrics to check out in finding out if a stock is overvalued or undervalued.
As a passive investor, I always encourage people not to be skeptic.
Most of the values are available when you view a company’s snapshot. Many brokers also share their forecast, news and updated Fair Value of stocks.
If you don’t want to check them one by one, we have some lists here in Dailypik, anyway.
The most important thing I should say here is focus on managing risk, execute your plan and objectives an as investor to reach your goals.