What is the PE ratio and how can we use it to find undervalued stocks
To determine if a stock is undervalued we are looking at the price to earning ratio (PE ratio). The PE ratio is used to measure the amount an investor needs to invest to receive one dollar of a company’s earnings. This can help investors evaluate if the share price is overvalued compared to others in the same sector or industry.
However, it is worth noting that to get a full picture of a stock there are several financial ratios you should use. Find out more here.
The PE ratio and the Aussie share market?
Morningstar is currently indicating that the market average PE ratio is approximately 20.4. However, this can change quickly when stock prices fluctuate. Over recent years the Australian stock market has demonstrated an increased risk of a decline when the market average PE ratio is hovering between 21 and 23. Whilst slightly below these figures now, over the course of 2021 the market has traded within this range which is an indication that the broader market is more fully priced rather than undervalued. Given this, while it is possible to find undervalued stocks in the current market, the number of opportunities are fewer and the short-term risk to investor capital has increased.
Typically, when a market is close to its peak and the PE ratios of big blue chip stocks are elevated, commentary about stocks being undervalued tends to be scarce and the focus shifts to stocks with low market capitalisation. In the current market conditions, PE ratios of less than 18 may still provide opportunities for growth, that said investors need to understand historical ratios for the particular stocks they are considering purchasing as even a ratio under 18 may not fully indicate an undervalued stock.
PE ratios in different sectors
To more accurately assess the PE ratio of a company you have to compare it to that of its peers, the other companies that are similar. For example, big Australian banks typically can trade with lower PE ratios and growth forecasts than Mining or Energy stocks that often exhibit higher PE ratios and higher earnings. Santos Limited (STO:ASX), for example, currently has PE ratio of 26.5 and two-year average growth forecast of 153% and these figures indicate there is still room for share price growth. Healthcare stocks also tend to trade with higher PE ratios and a good example in this sector is CSL Limited (CSL:ASX).
Here some stocks the could be undervalued:
Challenger Limited (ASX: CGF)
At current prices, there are few of the stocks worth putting on the watch list, including Challenger Limited with a PE ratio of 15 compared to the sector average of 22.7. Challenger provides annuities and retirement income products and operates a funds management business. If Challenger’s share price closes at the end of any week back up above $6 the probability of further growth in the stock price over the medium term will increase.
Silverlake Resources (ASX: SLR)
Silverlake Resources is a gold explorer and producer with a PE of 11.7. Although Silverlakes earnings are forecast to fall 23%, this is on the back of 1-year historical earnings of around 997% and a 5-year average of around 30%. Their share price must close at the end of any week above $2 to confirm the rise is likely to continue to around $2.40.
Ramelius Resources (ASX: RMS)
Ramelius Resources is also a gold miner and producer with a PE of 9.8. Morningstar analysts indicate the two year average earnings are currently forecast to grow by around 17% on the back of 1-year historical earnings of 384% and a five year average of 36%. RMS’s share price is currently down around 32% from its all-time high price of $2.53 in September 2020. A strong rise back above $1.90 would indicate a potential for RMS to trade to a new all-time high in three to six months. The risk of further falls in price increase if the stock were to fall below the recent low of $1.63 in July 2021.
RIO Tinto (ASX: RIO)
RIO Tinto is an iron ore miner and has business operations in aluminium, copper, diamonds, energy and minerals. The company’s PE is 7.8, and Morningstar data indicates a two-year average earnings forecast of 38%, on the back of a loss of 11.3% in the past year. In January 2021 RIO’s share price finally traded above the all-time high of $124.18 from May 2008 and has continued to hold above this level which indicates strength. RIO’s share price growth potential is likely to be between 12 and 25% in the second half of 2021.
ANZ (ASX: ANZ)
Australian and New Zealand Banking Group is the last one on our list and shouldn’t require an introduction. ANZ’s PE ratio is currently around 14, which by historical measures indicates that the stock is only slightly undervalued at current prices. However this is likely to change quickly, as the technical analysis indicates ANZ is likely to fall in price to between $24 and $26 in the short term. Investors will be looking for higher dividend yields, and the fall could improve the yield for new buyers.
Compare Online Share Trading Accounts with Canstar
If you’re comparing online share trading companies, the comparison table below displays some of the companies available on Canstar’s database with links to providers’ websites. The information displayed is based on an average of six trades per month. Please note the table is sorted by Star Rating (highest to lowest), followed by provider name (alphabetical). Use Canstar’s Online Share Trading comparison selector to view a wider range of online share trading companies. Canstar may earn a fee for referrals.