The Philosophy‍

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One key strategy many investors have used including Warren Buffet 🐐, is determining if a stock is under/overvalued. The idea behind it is that, if you can figure out a stock is undervalued you can buy it, because of the belief the stock will eventually find its way to a fair valued price.

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There are many fancy and overly complex ways of describing the approach to valuating stocks… but fuck that. You came for some valued information, not a headache. To simply put it, the approach to deciding a stock’s true price is by calculating the intrinsic value of that company and seeing if it is different than the current market value.

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Now you might ask what in the hell is the intrinsic value of a company. Good question. It is the calculated value of a company using fundamental analysis, which takes into account a variety of factors. It is these factors which I will show you that help us tell if that stock is under/overvalued.

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The Ratios

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Now I’d be lying if I said this was the one and only way to figure out under/over-valuations. We could do ten lessons on many different approaches.

Fortunately, there are some simple ratios and signals that can be helpful in determining whether a stock is cheap or expensive. It’s worth noting that no single metric is perfect and any use of these ratios or signs to determine business value should be considered along with a complete analysis of the company’s business and industry.

Here are some of the most popular valuation ratios that can show you if the stock price is measuring up to its performance.

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👉 P/E ratio

The P/E ratio is one of the most widely used ratios in investing. It compares a company’s stock price to its earnings per share. Generally speaking, If a stock has a low P/E ratio compared to its peers or the broader market, it may be undervalued, but there are many exceptions to that rule. A low P/E ratio could indicate that investors are not valuing the company's future growth prospects or that the stock is oversold.

In recent years, some companies had very high P/E ratios because interest rates were low. Investors were willing to pay more for these companies because they were growing. Amazon is an example. Even with a high P/E ratio, its stock did well because it reinvested earnings to grow. But in 2022, as interest rates rose, many of these high-P/E companies saw their stocks drop as investors worried about the impact.

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👉 PEG ratio

The PEG ratio compares a company's P/E ratio to its growth rate. A high P/E ratio for a fast-growing company is reasonable, so consider the growth outlook before relying only on the P/E ratio. A PEG ratio above 2 is usually expensive, while below 1 may suggest a good deal.

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👉 EV/EVIT

Now the EV/EVIT ratio is another commonly used ratio easily found online. I could go in depth to what the ratio compares and accounts for, but it’s a lot of financial metrics I don’t want to bog you down in. If you are curious a quick Google search should do the trick.

The key takeaway I want you to have from this factor is. To compare the EV/EBIT ratio of a company with others in the same industry. If there are differences, figure out why. Are they facing similar or different futures? If the industry outlook is similar, the valuation multiples shouldn’t differ much.

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👉 Price-to-sales

The price-to-sales (P/S) ratio is a fairly simple ratio. This ratio can be useful for companies that have low or negative earnings due to one-time factors or are in their early stages and investing heavily in the business. In the software industry, the P/S ratio can particularly help with the valuation, as companies often report negative earnings because they heavily invest in capital in the early stages.

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Other indicators

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Like I said there are many strategies to doing this. Before I wrap this up I want to put you on to some easy indicators that might mean an incorrect valuation.

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‍Company insiders are selling !!

As we discussed in our previous weekly lesson (link here). If a company’s CEO or CFO is not balls deep in the company. It smells suspect and nothing stinks quite like horse shit when these individuals start shipping stock like it’s black Friday. Yes, there are exceptions to the rule. Insiders may sell for any number of reasons that have nothing to do with what they think about the company’s valuation. Like tax purposes. However, keep an eye on it like you’re with your girl at the bar.

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The economic cycle is about to turn 🕘

I’m going to keep this brief as I feel the newsletter is long enough and I don’t want to take up more of your time. Cyclical companies' profits go up and down with the economy. They're tricky to value because they can seem cheap when the economy is strong and expensive when it's weak. But when their earnings are low, it might be the best time to buy. Just try to think beforehand about where you think the economy is headed and how that chosen sector could be affected.

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That’s all folks

I appreciate your time ladies and gents. I hope you were able to find value in today’s lesson. If you got this far you might as well subscribe below for more content.

Not financial advice, Full disclaimer here

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