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Good Value or Bad Stock? How to Tell the Difference

Wednesday, January 25, 2023 02:28 PM | Neal Farmer
Good Value or Bad Stock? How to Tell the Difference

Everyone always hears about trying to get stocks at a good value.

"Buy low, sell high," as the saying goes.

Look at the metrics to get the best possible value, but how do you actually determine what stock is a good value and which one is just a bad stock? After all, stocks that continue to fall look cheap all the way down.

Well there’s a number of ways to minimize how many bad stocks you pick and maximize the chance of choosing a stock that truly does offer a good value.

Nothing is ever fool proof but getting the most out of all the available information surrounding a stock can put the odds in your favor. These are the best metrics to use to help decipher the difference between good value and bad stocks.

PEG Ratio

The first and most important is also one of the simpler and most common metrics, the price/earnings-to-growth (PEG) ratio. PEG ratios are essentially just an enhanced version of the classic PE ratio that also takes into account a company’s growth rate. PE ratios are good but don’t always tell the whole story.

A company for example might have a higher than average PE ratio but is growing at a tremendous rate due to the market it's in, how long it’s been in business, or any number of factors. So the stock might have a high PE ratio currently but that isn’t taking into account its projected growth and if that growth is realized then the earnings part of the PE ratio will likely go up and thus bring down the overall ratio in the future.

A PEG ratio of one is usually considered a fair value.

PEG ratios are especially important for investors looking for capital appreciation while also looking to take advantage of solid valuation metrics in the market at the time. Bad stocks could have a solid PE ratio due to severe price drops but that will have less of an effect on the PEG ratio if the firm has proven itself incapable of substantial growth and/or shown no signs of improving in that area in the future.

Price/Book Ratio

A stock’s price-to-book (P/B) ratio determines the stock’s value by comparing net value to market capitalization. The P/B ratio divides the share price by book value per share giving a metric of how much investors are willing to pay for each dollar of a company’s net value.. The book value puts the focus on the company’s actual performance and worth instead of projections, helping traders avoid investing in mismanaged businesses.

A P/B ratio below 1 is considered undervalued as the stock’s market value is below the firm’s book value.

Debt/Equity Ratio

The debt-to-equity (D/E) ratio shows the proportion of debt to equity a firm uses to finance their assets. Higher D/E ratios indicate that the company derives more of its financing from debt than shareholder equity. Obviously higher debt becomes a risk to companies if they are unable to pay back those obligations.

A major factor when looking at D/E ratios though is that it's very relative to the industry and conditions of the company. Newer firms looking to take on debt in order to expand operations are different from hundred-year-old businesses that have had high debts for an extended period. Meanwhile, some industries naturally have higher debt levels if fixed costs are above average such as new automotive manufacturers needing large amounts of capital to start production while software companies typically have lower debt levels.

Free Cash Flow

Lastly, free cash flow (FCF) is one of the most commonly used metrics used by value investors as it shows the cash left over after expenditures are taken out. FCF shows how efficient firms are at generating cash and can often indicate earnings may increase in the future. A rising free cash flow often leads to earnings growth which leads to any combination of capital appreciation, dividends, and share buybacks that reward investors. Thus, the metric is a favorite among many for being a leading indicator of future performance much of the time.

Wrapping Up

None of the above metrics are some concrete rule. A stock with a good free cash flow is not guaranteed to see an improvement in earnings and higher dividends. It’s going over these metrics when trying to decide whether a stock is good value that they come in handy. All together they begin to paint a more complete picture of how a stock is trading and what the underlying health of the business is.

A stock with great metrics still after may continue to fall for some time if the market is just down on it or equities overall, but valuation ratios still can give a lot of valuable information and help improve the odds of betting on the right stock.

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