Welcome to Ameritrade Plus University
investing 101How to spot value
Aiming for a realistic return
Identifying your real risks
Putting together the right portfolio
The psychology of investing
Investing for growth
Seven questions to ask before buying a growth stock
How to spot value
Selecting stocks for income
How to buy bonds
Preferred shares: uncommon values
Convertibles: the best of both worlds
Closed-end funds: their time will come again
The right way to use stock options
Mergers and acquisitions
Frequently asked questions I
Frequently asked questions II
Stock screener

Take the quiz
The Sivy 100
About Investing 101

An interactive course for managing your finances


Finding bargains is an art, not a science. But there are rules for getting in at the right price.

All investors search for stocks that they think are good values -- after all, no one wants to overpay. But when stock pickers talk about value investing they mean something more specific: Looking for stocks that are so cheap their share prices can rise substantially if investors start viewing them more positively. That upward revaluation can occur because of favorable changes in a company's prospects, or even just because of a change in investor sentiment.

You generally can divide value stocks into two categories -- turnarounds and stocks with below-average P/Es. The former are companies suffering from depressed earnings because of business problems. If the companies have strong franchises and healthy balance sheets, they will be able to weather bad times, and earnings should eventually come back. But to invest successfully in turnarounds, you need to understand the specific nature of those problems -- whether, for example, they are unique to the company, or the result of external circumstances. And you need to decide whether management's plan for turning around the company is credible.

Profiting from low-P/E stocks is easier because there are benchmarks to guide you. Today, for example, the average P/E for all publicly traded companies is around 16 and that for the S&P 500 is in the high 20s. So any stock with a P/E below 20 could possibly qualify as undervalued.

But stocks can languish with low P/Es for long stretches of time, so it's best to look for a company that also has moderate earnings growth. It's a combination sometimes called GARP, for Growth At a Reasonable Price. GARP stocks should have most of the same characteristics as growth stocks, including a strong balance sheet and a record of steady earnings growth (probably in the 8 percent to 15 percent range).

The simplest way to tell when GARP stocks are cheap is to compare their P/Es to their earnings growth rates (that's called the PEG ratio, or P/E to Growth). In this market, stocks with P/Es lower than their growth rates are very cheap. It's also helpful to add a stock's dividend to its earnings growth rate to get a gauge of potential total return and use that number to figure the PEG ratio. Auto-parts maker TRW, for instance, has projected earnings growth of 9 percent and a dividend yield of more than 4 percent. That 13 percent-plus potential total return is quite attractive, considering that the P/E is less than 10.

Few depressed stocks stay down forever. And once a value stock rises, you have to decide whether to continue holding it. Since there won't be much room for further P/E increases, the stock is only worth hanging on to if it offers a total return (based on earnings growth and its dividend yield) totaling more than the market's 12 percent long-term historical average. Otherwise, it's smarter to cash out and use your profits to buy another unappreciated gem.

Selecting stocks for income >>


Copyright 2000-2001 Time Inc. All rights reserved. Reproduction in whole or in part without permission is prohibited.