There’s no question that Warren Buffett is an investing genius, but he’s made his fortune by following one simple rule: Buy undervalued stocks. That doesn’t mean purchasing the cheapest priced stocks. It means buying into good companies that for one reason or another — maybe an expansion went sour or the CEO quit — the stock price has fallen.
You have to look at valuations, or metrics, to determine whether a company is cheap or not. You want to buy a business with low valuations in the hopes that those numbers will grow over time. If they grow, the stock price will rise.
You can look at numerous metrics, but here are a few valuations to start with:
1. Price-to-earnings ratio?
This is one of the most important numbers to look at. The calculation is based on the company’s share price compared to its per share earnings, so basically it’s about how much investors are willing to pay for each dollar of a company’s earnings.
A low price-to-earnings (PE) ratio usually means a company is cheap; a high one means it’s expensive. How high is too high depends on the industry and the other companies in that sector. A good way to look at it though is what’s the PE compared to the average PE of an index, such as the S&P 500. That index’s PE is around 14.5 times earning today — anything less could be considered cheap.
Price-to-book, or PB, is another common valuation that financial experts consider. To get the number, you divide the share price by the book value. Book value is the total value of a company’s assets — the total assets minus liabilities. (You can find this information in annual reports or by reading analyst reports.)
This metric tells you how much you’re paying for the company’s assets. Like with PE, the lower the PB, the cheaper the company. Most fund managers like companies with book values around one or below, though it depends on the sector.