I find that I often have more ideas and stocks to buy than I have free cash to invest. I doubt that I’m alone in that. Yet if I put the shoe on the other foot, what if I have £1k ready to go now? In that case, I need to filter for a way to find some cheap shares to buy. Here are three ways that I go about screening for good value.
Looking at the past year
The first technique I use is historical performance. The classic financial disclaimer states that “past performance is no guarantee of future returns.” The message is clear that just because a stock has moved a certain way in the past, it doesn’t mean that this will continue in the future.
It’s as true for stocks that have fallen as those that have risen. Just because a share has dropped by X%, doesn’t mean that it’s going to fall to zero.
So as a first step to look for a cheap stock, I filter for companies that have dropped by at least 20% in value over the past year. At present, there are 12 stocks in the FTSE 100 that fit this description. Granted, some of these have genuine problems that would make me want to avoid buying. But the filter can at least help me to make a start.
Tying in share price movements to financials
The second level beyond just pure share price movements is comparing that to the change in company earnings. For example, a stock might have fallen by 50%, but earnings might have only dropped by 10%. In that case, the overreaction by investors could mean the stock is undervalued.
Fortunately, I don’t have to do all the maths by myself. The price-to-earnings (P/E) ratio gives me a figure that represents this value. The higher the number the more chance that the share is overvalued, whereas a low number can indicate the opposite. There’s no hard and fast rule on what a low number is, I personally use anything below 10 as a line in the sand for being good value.
Filtering for stocks with low P/E values can be a great way to spot some opportunities. As a side note, the ratio only works for businesses that are making a profit. This is a limitation, as I can’t get a handle on value if the firm is currently loss-making.
Filtering for earnings growth
The final layer I can add is to take into account the projected growth rate of earnings. The P/E ratio is great, but takes the latest reported earnings per share.
Some shares can be cheap because investors aren’t factoring in the large growth potential in future earnings. If two stocks had the same P/E ratio but one was due to grow earnings by 50% next year and the other was likely to be stagnant, I’d place greater value on the first company.
For this, I can use the price/earnings-to-growth ratio (PEG). This takes into account not just the share price relative to earnings, but the expected growth rate of the earnings. If the ratio is below 1, it can indicate an undervalued stock.
