Identifying cheap stocks during a market slump can be daunting, with prices in the red and no sign of a recovery on the horizon. However, there are some key indicators I look for that I think help me identify stocks with the potential for recovery.
Below I explain how these figures are calculated. But you needn’t do the hard work — for most listed companies, these figures are easy to find online.
Past and expected growth
Looking back on a company’s historical growth can help me get a good idea of where it might be headed. To do this, I first get the compound annual growth rate (CAGR), which gives me a good idea of the company’s rate of returns over the past 10 years. I then multiply the last datum of the series by (1 + CAGR) for each year ahead I want to forecast. Naturally, the further ahead I forecast the higher the likelihood of error, but it gives me a rough idea.
This is a good place to start, allowing me to formulate a relatively good estimate of whether a stock is likely to grow or not. However, to get a better idea, I do the calculations below to discover undervalued companies that are below liquidation value with good potential for growth.
Low price-to-earnings (P/E) ratio
A low price-to-earnings (P/E) ratio is a great indicator of a stock that has growth potential. To calculate the P/E ratio of a stock, I divide the market value per share by earnings per share (EPS):
P/E ratio = market value per share / EPS
This calculation measures a company’s current share price relative to the earnings made from each share. In other words, the P/E ratio tells me how much investors are willing to pay for each pound of earnings that the company makes. If a company has a lower P/E ratio than similar companies in the same industry, I believe that’s a sign the stock’s true value is yet to be fully realised.
With the P/E ratio, I can then go one step further and calculate the price-earnings-to-growth ratio (PEG). To do this, I divide the P/E ratio by the percentage growth in annual EPS. I believe a company with a low PEG ratio but steady earnings may be undervalued.
Low price-to-net current asset value (P/NCAV) ratio
This one is a bit more complicated but is an easy enough ratio to find online without having to do the calculations.
P/NCAV ratio = (Market Value Per Share) / Net Current Asset Value (NCAV) Per Share
The P/NCAV ratio is essentially a calculation of a company’s working capital. But rather than factoring in current liabilities, it factors in total liabilities and preferred shares. With this approach, I get a good idea of a company’s liquidation value. I would look for a stock that is trading somewhere in the lower two-thirds of the P/NCAV ratio.
This is not a fully exhaustive list of indicators I would look for when searching for cheap stocks. However, it gives me a good idea if I’m on the right track or not.
