With the holiday shopping season in full bloom, everyone is busy scouring the internet for great bargains on presents. Everyone loves a good bargain, and this is the time of year when retailers are offering the best bargains on their products, but there are also some good bargains to be had on Wall Street.
Finding a “bargain” is not the easiest thing to do in investing. The basic premise behind the stock market is that at any given moment, all information available on a stock is already known. As a result, you can assume that a stock's price already reflects all available information, and is priced correctly. Based on this basic premise, there really should not be bargains… simply stocks that are perfectly priced to reflect all information available on a company.
However, as we all know, this is not how things work out. There are plenty of times when the market is slow to react, or is simply unwilling to get behind a stock regardless of positive news or optimistic forecasts. This is where bargain hunters are able to swoop in and pick up shares at a discount.
The easiest way to find bargains is to compare how a stock is valued versus its peers. We can do this by comparing price-to-earnings ratios. If you see several stocks in a sector trading with P/E ratios in the upper 20s, and one trading below 20, you can reasonably assume that a stock is undervalued.
There are plenty of reasons why this may occur. Perhaps the other stocks have larger earnings growth forecasts, or the undervalued stock has recently announced some bad news such as an earnings miss or management change. A lower P/E ratio, on its own, is not reason enough to jump into a stock… the fundamentals must back up the decision.
For the purpose of our discussion, we are first going to look at stocks with low P/E ratios versus their peers, and then dig a little deeper to make sure there are other reasons to jump into the stock. Stocks that pass both tests will be considered good bargains at their current price.