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How To Find Undervalued Companies Using The Price Earnings Ratio

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Faisal Khan
@fhk007
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Being a financial analyst, I have been involved in finding undervalued companies (stocks) that can deliver robust returns in the medium to long-term.

One way to find attractive companies in the price earnings ratio (PE ratio). This is the most commonly used valuation measure. However, it is largely misunderstood.

I want to provide some insights on how investors can use the PE ratio to find undervalued companies.

Let’s start with the general misconception.

It’s as follows - Companies that have a low PE are undervalued and companies that have a high PE are overvalued.

First, let me explain what is the PE ratio.

In very simple words, it’s the price an investor is willing to pay in the markets for every dollar of the company’s earnings.

Assume Company X has an earnings per share of $2. Further, Company X stock is trading at $20.

Therefore, the company is trading at a PE ratio of 20 / 2 = 10.

Now let’s look at a real example.

JD.com (A Chinese e-commerce company) currently trades at a PE ratio of 53.87.

Alibaba (Another Chinese e-commerce company) currently trades at a PE ratio of 31.09.

If an investor looks at this, it seems like Alibaba is undervalued as compared to JD.com.

However, JD.com is expected to show annual earnings growth of 49.7% over the next five years.

Alibaba is expected to show annual earnings growth of 19.8% over the next five years.

Let’s calculate the price earnings to growth ratio (PEG) for both these stocks.

JD.com PEG = JD.com PE Ratio / JD.com Expected Growth = 53.87 / 49.70 = 1.08

Alibaba PEG = Alibaba PE Ratio / Alibaba Expected Growth = 31.09 / 19.80 = 1.57

Therefore, based on the PEG ratio, JD.com is undervalued as compared to Alibaba.

Note that I am comparing companies in the same industry. It’s also important to compare companies of the same size.

A small high growth company will have a high PE ratio as compared to a big company in the same industry.

Therefore, the key learning is that the PE ratio is not enough on a standalone basis. Investors need to look at the PEG ratio. In other words, the company’s expected growth needs to be factored.

The PEG ratio will help in finding attractive companies across industries.

I do believe that JD.com is an attractive investment. While Alibaba is also good, JD.com seems attractive on a relative basis.

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