How to Tell If a Stock Is Undervalued
By Sean Wade · 7 min read ·
Quick answer
A stock may be undervalued when its price is low relative to what the business earns or is expected to earn. Investors typically compare valuation ratios like P/E, PEG, price-to-sales and free cash flow yield against the company's own history, its peers and its growth rate — no single ratio is enough on its own.
Price vs. value
Price is what you pay; value is what the business is worth based on the cash it can produce over time. A stock is "undervalued" only relative to a reasonable estimate of that value — which is why valuation always involves assumptions.
Key valuation ratios
- P/E ratio: share price ÷ earnings per share. Shows how many dollars investors pay for $1 of earnings. Forward P/E uses expected earnings.
- PEG ratio: P/E ÷ expected earnings growth rate. Adjusts P/E for growth; around 1 is often viewed as roughly fair, though conventions vary.
- Price-to-sales (P/S): market cap ÷ revenue. Useful for companies that aren't yet profitable.
- Free cash flow yield: free cash flow ÷ market cap. Higher yields mean more cash generated per dollar invested.
- EV/EBITDA: enterprise value ÷ EBITDA. Accounts for debt, so it's helpful when comparing companies with different balance sheets.
Compare in three directions
- Against its own history: is the multiple below its typical range?
- Against peers: how does it compare with similar companies in the same industry?
- Against growth: a high multiple can be fair for fast growth; a low multiple can be a trap if earnings are shrinking.
Watch out for value traps
A low P/E can mean the market expects earnings to fall. Check revenue trends, margins, debt levels and whether earnings are one-time or recurring before deciding something is cheap.
Discount, fair, or premium?
Dragon Investing's free valuation course walks through a simple framework for placing a stock into one of three buckets — discount, fair or premium — using these ratios, with quizzes and a built-in calculator.
This article is for educational purposes only and is not financial advice. Investing and options trading involve risk, including loss of principal. Do your own research and consider speaking with a licensed professional. See our disclaimer.