How to Identify an Undervalued Stock

It's not easy to find a great stock. In almost every case, investors have already priced good and bad news about the company into the stock's share price. But every once in a while, the market misprices a stock. So how do you find these hidden gems?

A company's price-to-earnings ratio, or P/E, is one of the fundamental metrics that every stock picker should know. It's is a great place for every investor to start when trying to find undervalued stocks to purchase.

How to Calculate a P/E Ratio

To calculate a company's P/E ratio, simply divide the share price of a company's stock with its earnings per share. (For an apples-to-apples comparison, be sure to calculate the ratio on a per-share basis.)

For example, if a company has a share price of $40 and earns a profit of $2 a share, its P/E ratio is 20. If the company's price per share were to increase to $60 and its profits remained the same, it would see its P/E ratio jump to 30.

P/E Ratio Shows You If a Company's Stock Is Undervalued

A company's P/E ratio is a leading indicator of an undervalued stock. A lower P/E ratio shows investors that a lower-priced stock is earning a larger profit. A higher P/E ratio indicates that a stock is more expensive or might not be earning a lot of profit when compared to the price of a share of its stock.

P/E ratios are relative, and should only be compared to those of other companies within the same industry or sector. %VIRTUAL-WSSCourseInline-630%So, it isn't fair or even accurate most times to, for example, compare the P/E of a technology company with that of a consumer products company, as these industries typically have different P/E ratio levels.

Technology companies frequently command a higher price for their stock, despite the lack of big profits. It isn't unusual to see some technology companies with a P/E of 40 or more. Conversely, consumer staples and blue chip companies often have a lower P/E. It's important to compare companies within their own industry to identify buying opportunities.

Compare Companies Within Industries for the Most Insight

One of the best ways to find a stock to invest in is to compare a company to its industry average. You can easily find the P/E ratio for industries and even entire indexes online. They will provide you with a baseline for comparison.

For example, Dr. Pepper Snapple Group (DPS) had a P/E ratio of 15.45 at yesterday's closing bell. %VIRTUAL-article-sponsoredlinks%Dr. Pepper's largest competitor, the Coca-Cola (KO), has a P/E Ratio of 20.68. National Beverage (FIZZ), the maker of Shasta and other popular sodas, has a P/E ratio of 21.96. And, on average, the non-alcoholic beverage industry has a P/E ratio of approximately 20.7.

So what do these numbers tell us? Solely using the P/E ratio as the only metric, Dr. Pepper Snapple Group looks undervalued compared to its peers. Dr. Pepper's current share price is $47.72. If the company had a P/E ratio comparable to Coca-Cola's 20.68, then investors should actually expect the price of Dr. Pepper's stock to be closer $63.90 a share.

This is a quick example to show you how to use a company's P/E ratio to find potentially mispriced stocks. Investors compare companies to others in the same industry. It shows a potentially undervalued stock. While there are a few other characteristics that make Dr. Pepper and Coca-Cola a little different from each other, the P/E ratio presents an opportunity for investors and warrants more investigation.

When you examine a company's P/E ratio, you can quickly identify many price inequalities. It's a great tool and should be the first metric investors use when looking for a new stock.

Do you use the price-to-earnings ratio to find great companies to invest in? Is it the first metric you scrutinize when buying? What other key metrics do you look at to find a great stock?

Disclaimer: I currently own shares of both Dr. Pepper Snapple Group and the Coca-Cola Company. I continue to purchase new shares each month using dollar cost averaging through both companies' dividend reinvestment plans.

Hank Coleman is a financial planner and the publisher of the popular personal finance blog Money Q&A, where he answers readers' tough money questions. Follow him on Twitter @HankColeman.

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