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Here’s how to tell if a stock is cheap

The ASX/S&P 200 (ASX: XJO) is up 22.5% over the past 12 months, pushing the market price-to-earnings ratio to around 16, well above the long-term average of between 14.5 and 15. During this time, the share price of most blue-chip stocks has risen strongly to the point where they are no longer considered cheap by most commentators.

Investors are therefore starting to search far and wide for companies that provide better value, particularly in the mid and small-cap category, where many stocks have underperformed the wider market.

But how does the humble investor do a quick check to see if a stock is cheap? A top-level analysis allows the investor to decide whether the stock is worth more investigation. The three (larger) stocks I’ve chosen as examples are the National Australia Bank (ASX: NAB), AMP (ASX: AMP) and hearing device company Cochlear (ASX: COH).

The first check an investor can do is look at the PE ratio of the company. Of interest is the company’s current PE ratio, that of the sector it operates in, the market, and also the company’s historical PE ratio. All of these values can be found on Australia’s major online broking sites such as Comsec and ETrade. A lower PE ratio indicates better valve; the table below shows the details for the three companies.

Current PE Market PE Sector PE Historical PE
NAB 13.8 16.1 14.7 11.0
AMP 15.0 16.1 17.1 14.0
COH 25.0 16.1 22.8 24.0

As can be seen, all three are currently trading above their historical averages, while Cochlear is trading above its sector average PE. On a very high level, this indicates that either the company’s share price has risen before its earnings, or that its earnings have fallen more than its share price.

Now, in times such as these when the majority of quality companies are trading above their historical PE ratios, it’s worth considering those that are underperforming in their sector, such as NAB and AMP. At current prices you may want to avoid Cochlear, as it appears overpriced based on its historical and sector PE. Digging into the company further, you would also find that earnings per share are expected to fall this year, which is potentially cause for concern.

The next consideration is the company’s earnings per share over time. As mentioned above, the best companies will consistently grow earnings per share over time. This indicates that profits are rising and that (most likely) shareholder equity isn’t being wiped out by the issue of new shares. This information can also be found on Australia’s major online broking sites.

Since the GFC, Cochlear has had earnings rise from 233 cents per share in 2009 to 308 cents in 2011, but it has since fallen back to 232 cents in 2013 as the company has been slow to release new products to the market. Meanwhile, AMP has seen earnings steadily drop from 38 cents per share in 2009 down to 33 cents per share in 2012, with little prospect of a significant recovery this year. NAB, in contrast, has grown earnings from 189 cents in 2009 to 249 cents in 2013, with only one small decline in 2012.

Finally, once you have discovered a stock that satisfies the above criteria, it’s worth looking at the sustainability of its dividend and its competitors’. Is the dividend at the upper end of the company’s stated pay out range? Are there sustained threats to the business from bigger or more cashed-up rivals? This could present an opportunity for either a takeover or falling earnings depending on the rival. The dividend is important because a company with a falling dividend will receive less support from investors than one that is raising dividends.

Foolish takeaway

Picking stocks is hard. The short analysis described above will help investors narrow down potential stocks based on their fundamentals. As all Foolish investors will know, past performance is no guarantee of future returns; thus the next step is to investigate the outlook for the company over the next few years.

In this case, NAB came out on top. It has forecast low single-digit earnings growth over the coming years and sustained high dividend payouts. This may suit defensive investors over the long term.

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Motley Fool contributor Andrew Mudie does not own shares in any of the companies mentioned.

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