Following a rocky 2022—during which nearly three-quarters of the stocks in the S&P 500® Index lost ground1—many investors are now on the hunt for potential deals. But how do you know if a stock's price has fallen enough to be a bargain?
Unfortunately, just because a stock is cheaper doesn't necessarily make it a good value. You'll need to look under the hood, so to speak, to assess its prospects. These four measures of financial strength, when considered together, can help you determine whether a stock is over- or underpriced.
1. Trailing price-to-earnings (P/E) ratio
This backward-looking metric is calculated by dividing a stock's current share price by the past 12 months of actual earnings per share (EPS). The higher the ratio, the more expensive the stock is compared with its earnings, so a relatively low ratio may indicate the stock is undervalued. Relatively is the key term, however, because what constitutes an attractive P/E ratio varies by sector—which is why you'll want to compare the stock's trailing P/E ratio with those of its peers.
2. Forward P/E ratio
This metric measures anticipated future performance, dividing the stock's share price by the company's forecast EPS. A higher forward P/E ratio shows how expensive a company's share price is compared with its earning potential.
However, when calculating forward P/E, analysts use forecasts based on the company's reported estimates for future earnings, which aren't always reliable. Some companies may be overly optimistic about their earnings potential, while others may be purposely pessimistic to more easily beat their own estimates and therefore market expectations.
That's why it can be helpful to compare a company's forward P/E to its trailing P/E (in addition to comparing it with its peers). If the numbers diverge significantly, it's worth taking a closer look at the company's earnings estimates or news coverage of its business to better understand the disconnect.
3. Estimated EPS growth
Estimated EPS growth is based on the mean estimate from polled analysts of how much they expect a company to be able to boost its profits on a per-share basis. A higher EPS growth estimate relative to peers is generally a good sign that a stock is undervalued. However, if the company fails to meet its earnings forecasts, its share price may suffer.
4. Estimated revenue growth
This forward-looking metric is the best gauge of demand for the company's goods or services and can be particularly helpful when analyzing newer companies that haven't yet posted positive earnings. A company can always fall short of its projected growth, but higher estimated revenue growth relative to peers could still signal an opportunity.
Because of each metric's shortcomings, it's best to consider them together when assessing the merits of a potential stock. A company might not look great in a single category but could outshine its peers when the metrics are viewed collectively. If a stock stacks up well against its peers in all four categories, it will likely have a far better chance of performing favorably over the long run.
How to compare stocks on schwab.com
To help determine whether a stock could be over- or underpriced relative to its peers, log in to the stock screener tool (schwab.com/stockscreener) and select the following criteria:
- Under Basic, select Same Sub-Industry As and enter the company name or stock symbol.
- Under Company Performance:
- In the Estimated Revenue Growth section, select Next Year.
- In the Estimated EPS Growth section, select Long Term.
- Under Valuation, select Price/Earnings (TTM) and Price/Earnings (FYF).
The resulting list will display the available data for all companies in the same subindustry, which can help determine what's "normal" for that subindustry and put an individual stock's performance in perspective.
1U.S. Equities January 2023, S&P Dow Jones Indices, pg. 6, 02/02/2023, www.spglobal.com/spdji/en/documents/commentary/market-attributes-us-equities-202301.pdf.
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