One of the first mistakes new investors make is equating a stock's price with its value. Some see a stock with a low price as cheap and one with a high price as expensive, but price by itself is irrelevant. A stock with a low price can be overvalued, and a stock with a high price can be undervalued. The price only tells part of the story; what you should focus on is the value.
One of the easiest indicators of a stock's value is its price-to-earnings (P/E) ratio. It's not a foolproof method, but hell, what is when it comes to finances?
One of the easiest ways to tell if a company's stock is overvalued or undervalued is to check out its P/E ratio. Long story short: A company's P/E ratio tells you how much money they make relative to their stock price.
To avoid sending you into REM sleep and making things more complicated than they need to be, we can skip the math behind the P/E ratio. Luckily, almost all platforms you use to buy stocks will tell you a company's P/E ratio—no math needed. If they don't, that's your sign to choose a different brokerage company.
The P/E ratio basically tells you how much you're paying for your portion of the company's earnings. The lower the P/E ratio, the better.
You can't just look at a company's P/E ratio and automatically determine if it's overvalued or undervalued because different industries have different ranges of what's considered "good" or "bad." Companies in fast-growing industries like tech will likely have higher P/E ratios than those in older industries like agriculture.
If you're comparing Google's P/E ratio to Procter & Gamble's P/E ratio, you're wasting your time. If you want to know if Apple's stock is overvalued, compare it to a company like Microsoft; If you want to know if AT&T is undervalued, compare it to companies like Verizon and T-Mobile. You wouldn't want to compare Coca-Cola with Tesla.
Let's imagine that Big John's retail store has a P/E ratio of 20. If you look at a few other retail stores and all of their P/E ratios are between 35–40, Big John's is likely undervalued. However, if those other retail stores have P/E ratios around 5, Big John's is probably overvalued.
Looks can be deceiving; anybody whose ever been at the bar or club when the lights come on after last call can tell you that. Sometimes when people are determining a stock's value, they do it with their 1:30 am club eyes and get caught in what's considered a value trap.
A value trap is a company that looks good on the surface, but once you hit the switch, it starts looking funny in the light. It seems undervalued, but it's not.
Some industries—such as construction, auto manufacturing, real estate, and telecommunications—are notorious for catching investors in the value trap. These industries go through more ups and downs than reality TV couples, and if you're not aware of the "cycle" you're in, you could get caught slippin'.
When the economy is good and expanding, more people are buying cars, more homes and buildings are being built, and people are more interested in extra services. This causes these companies to have large increases in profit that are unsustainable long-term. These high earnings translate to low P/E ratios and cause the companies to look wildly undervalued.
You might look at the stock and think it's an easy come up, and the whole time you're hustlin' backwards. It happens every day. Ironically enough, these businesses are generally undervalued when their P/E ratio is high and undervalued when it's low. You'll need to use other figures to determine value when this happens.
Avoiding Value Traps
The best way to avoid value traps for most people is to avoid buying individual stocks and sticking to funds (preferably index). The average investor isn't going to go through a company's financial statements, and even fewer have the finance or accounting skills needed to evaluate it properly. It might sound harsh, but that's just the reality.
Investing in funds takes away the work and lets someone else do it for you. Instead of picking out individual tech companies, you can invest in a tech-focused fund. Instead of researching individual healthcare companies, you can invest in a healthcare-focused fund. Want to invest in big companies across many industries? There are funds for that, too.
You wouldn't pay $5 for a Snickers because you know it's not worth that, no matter how small $5 may seem. Use the same principle with stocks. Just because the price is low doesn't mean you should pay for it.