When you are looking for a stock to invest in it is helpful to know which sectors of the market are being underpriced or overpriced by investors in the stock market.
Underpriced means stocks were selling near or below the market fair value and overpriced means stocks are selling over their market fair value.
This is important when you are looking for an individual stock to invest in since tells you whether other stocks in the market and more specifically in the same sector as your investment candidate are trading over or under the market fair value.
But, how do you know whether the market is underpriced or overpriced and more specifically how do you know peers of the investment candidate are underpriced or overpriced?
Fortunately MorningStar has a nifty tool that can provide you some great information and even better, it's free.
Under the market fair value tab you will find a chart that covers a variety of industrial sectors and plots whether stocks in that sector or being overvalued or undervalued by the stock market.
Their yardstick is based on the market for value fair value in these sectors that MorningStar has calculated using its own proprietary system.
The graph plots the ratio that compares market prices to MorningStar's market fair value. The result is a ratio above 1 suggests the stock's price is higher than MorningStar's estimate of the fair value. If the ratio is below 1, that indicates the stock is priced lower than MorningStar's market fair value for the stock.
The sectors and industries covered by this tool will give you a broad overview of how the market is pricing various stocks. When you focus on a single stock you can find the same ratio under current value ratio and listed as the price to fair (I used General Electric to generate the link).
This tells you how an individual stock is priced relative to the market fair value that MorningStar has assigned to it.
The simple conclusion is stocks that are undervalued are the best candidates and that's certainly true when it comes time to buying a stock. However that's not the whole story and you will need further analysis of the company to determine if this is a great company and whether you wish to invest in it.
After all, any company can have a great quarter or so, but that doesn't mean they are great stocks.
There are many other tools on the Internet to help you come to these conclusions, however I think MorningStar does as good a job as anyone in providing comprehensive information about the broad market, stock sectors, and individual stocks.
Most of the information is free. When you want to drill down to an analysis of an individual stock you will need to subscribe to their service. I found that the subscription is well worth the money in terms of the time and effort it will save you in researching individual stocks for investment.
It should be noted, that I have no affiliation with MorningStar and receive no compensation in any form from them.
For many people, digging up the information is half the fun of investing. If you want to calculate your own valuation ratios or other metrics, please feel free to do so.
However others just want to get to the heart of the matter as quickly as possible. Either way you have to do your homework before deciding if you want to buy a great stock at a great price in a great company.
The importance of comparing an investment candidate to others in its sector is very important in the decision-making process. This is where you can see if a company is way out of line with its peers and ask yourself why.