4 Indicators for Undervalued Stocks

There are several indicators for undervalued stocks that you can use to assist you in the investment process. There are both fundamental and technical indicators of when a stock may be a good value and a good buy. The following four indicators can help you select attractive stocks to add to your portfolio.

Fundamental Indicators

1) Price-Earnings-to-Growth Ratio (PEG)–To calculate the PEG ratio, a stock’s price-to-earnings (P/E) ratio is divided by the expected growth rate. The P/E ratio is calculated by dividing the stock’s price by the company’s earnings per share. Adding the growth rate makes the metric more applicable when you are comparing companies in different industries. In general, a company with a PEG below 1 is considered attractive. The P/E tells you how much you are paying for every dollar of earnings. When the PEG is below 1, the company’s growth more than justifies the price you are paying.

2) Dividend Yield–The dividend yield is calculated by taking the stock’s annual dividend and dividing it by the price of the stock. The resulting percentage tells you how much you will earn by simply holding the stock, regardless of the performance of the stock itself. Stocks with significant dividend yields are considered good values because you will earn a reasonable return by just holding the stock. Under this approach, you can hold the stock over the long-term and more easily weather hard times for the stock’s price. If the dividend yield is too high, however, this can be a warning sign. A dividend yield over 10 percent, for example, suggests that the company is trying too hard to entice people to buy the stock. It may also indicate that the price has fallen very significantly. A company can always lower its dividend. If you buy a stock with a dividend that is too high, you may never see the return for which you are hoping.

Technical Indicators

3) Relative Strength Index (RSI)–A stock’s RSI is calculated by comparing the numbers of buyers and sellers present in the market over a past number of days. The calculation differs for each time period, but most charting software provides this number for you. An RSI below 20 indicates that the stock is oversold. This means that the sellers have pushed the stock too low and are running out of power. As equilibrium returns, you should see a bounce in the stock. This is called a contrarian indicator because a low reading is positive for the stock in question.

4) Moving Average–The moving average is determined by calculating the average price for the stock over the previous period. Common durations are 10-, 50- and 200-day moving averages. This indicator is usually expressed graphically as a line that smooths the price action of the stock you are watching. When a stock’s price crosses a moving average to the upside, you should buy the stock because this is considered a sign of positive momentum.

Using these and other indicators can help you select undervalued stocks to add to your portfolio. Indicators alone are rarely enough to make an educated investment decision. Additional research is always advisable.

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