What is the best way to find a value stock? The price-to-earnings (P/E) ratio is probably most investors go-to metric. But this metric has issues with its application and limitations. Using it to delineate growth stocks from value stocks, is not the same as using it to determine if a stock is cheap or not. As for limitations they are many, but the P/E ratio remains useful if applied correctly in relative valuation, especially when using forward looking data and in combination with other metrics.
Similar assets should have similar prices
A value stock is not necessarily undervalued and a growth stock is not necessarily overvalued. It is the average P/E ratio of a market that stands as the differentiator between growth and value stocks, the former having a P/E ratio higher than the market average and the latter lower. All P/E ratios should use a forward estimate of earnings of possible. Investing is more about the future than the past after all, but comparing one forward P/E to a trailing-twelve month one for another stock should be avoided.
But, talking of a stock being over or undervalued only makes sense when comparing it to its peers. A key tenet of investing is that similar assets should cost the same. Thus, a undervalued asset is one that is a lot like another one but it’s cheaper. I’d still the use the P/E ratio to determine if a stock is under or overvalued, but the comparison would be other stocks, perhaps from the same industry, but ideally in even more similar groups, perhaps at the sector or subsection level.
For example, take the containers and packaging subsector. This is part of the general industrials sector, which is part of the industrial goods and services supersector, which is part of the industrials industry group. An undervalued or overvalued analysis could occur at all levels, but the bigger the group the less meaningful comparison.
UK containers and packaging stocks
There are six containers and packaging stocks listed on the London Stock Exchange.The average P/E ratio for the group is 10.5. DS Smith, Coral Products and Macfarlane have P/E ratios below 12.0, and so may be considered undervalued. However, is this really a fair comparison?
| Name | Ticker | Market Capitalisation | Forward P/E ratio |
| Mondi | MNDI | £7,755m | 11.6 |
| DS Smith | SMDS | £5,024m | 9.3 |
| Smurfit Kappa | SKG | £9,190m | 11.3 |
| Robinson | RBN | £17m | 12.5 |
| Coral Products | CRU | £15m | 8.3 |
| Macfarlane | MACF | £181m | 9.8 |
Three stocks are titans with market caps in the billions, the rest are measured in the hundreds or tens of millions. Remember, similar assets should trade at similar prices. I would therefore dividend the stocks in this subsector into at least two buckets by their market caps.
Are all value stocks undervalued?
One bucket would include Mondi, DS Smith and Smurfit Kappa. The average here is 10.7 so DS Smith looks undervalued and the others overvalued when considered as a group. The other group has an average of 10.2, so Robinson appears overvalued and the rest undervalued.
Mondi appears overvalued when compared to its peers of similar size in the containers and packaging subsector. But it is a member of the FTSE All-Share and FTSE 100 indexes which have P/E ratios of 12.6 and 14.4 respectively. With a P/E ratio of 11.6, Mondi looks like a value stock as its number is less than the index (market) average. So, it is an overvalued (compared to peers) value stock (compared to the wider market).
The P/E ratio is not enough on its own
The P/E ratio is useful in deciding between growth and value and overvalued and undervalued. But used alone it might cause problems. A stock that is undervalued might deserve to be so. The expectation with undervalued stocks is that they should close the gap with their overvalued peers. But a stock might be trading at a comparatively low P/E ratio because it is in trouble.
When picking a stock an investor needs to do more than look at the P/E ratio. Ideally, they should learn all there is to learn about the company, dive into its financials and determine its likely future. If a low P/E ratio prompts that kind of in depth research and indeed the stock looks like a bargain than that’s all well and good. But they could reduced the amount of stocks that need in-depth research by combining the P/E ratio with other measures.
One such measure is the PEG ratio. This divides the P/E ratio by the forecasted percentage of earnings growth. Results less than one are growth at a reasonable price stocks, over one and an investor might be paying though the nose for growth. The current ratio is good for a quick assessment of whether a company might struggle to meet its short term obligations—it is a liquidity ratio. A solvency ratio like the debt-to-equity ratio, measures a company’s ability to meet its long term obligations. Efficiency ratios like the cash conversion cycle measure how well a company is using its assets and profitability measures like gross and operating margin demonstrate, well, profitability.
A decent screen for value or growth, or undervalued or overvalued stocks should include additional screening measures like these to make the list of stocks manageable and to prevent falling into a value trap. I would also throw in the price-to-sales (P/S) ratio to any search like this.
If the P/S and P/E ratios agree, that is both are under or over the average for the peer group if looking at relative value, or the market if determining growth or value status then I have more confidence in the assessment. If they give different results then finding out why might be revealing. They use different denominators, sales and earnings, so serve as useful guides to possible dislocations between the top and bottom lines of the income statement.
Pricey value and cheap growth
There could be situation whereby all U.K. value stocks are undervalued then. Or they could be overvalued. U.K. growth stocks could be pricey or cheap. The point here is that growth vs value is determined by reference to market averages. Cheapness and expensiveness are determined relative to peers.
DISCLAIMER: James J. McCombie does not own any of the stocks mentioned. The Storied Investor does not have a beneficial ownership position in any of the stocks mentioned.
The Storied Investor 