How to find undervalued stocks in the wake of last year’s big selloff - and three that top value investors may approve of

After letting off steam late last year, stocks have bounced back in a post-holiday rally that gives some rays of hope for investors.

While companies are resetting earnings growth expectations lower this year, last year’s stock sell-off means there are likely some real bargains out there.

One of the most widely used yardsticks used by investors to judge whether a stock is overpriced or undervalued is the price-to-earnings ratio, or earnings multiple. It is supposed to reflect how much investors are willing to pay for $1 of a company’s earnings.

A higher ratio means investors are paying a higher price for the stock because they believe future performance will be strong and pay off in profits for them. A lower ratio either means investors are getting more bang for their buck in the form of an undervalued stock, or they aren’t as confident in the company’s future.

Stock valuations soared in 2017 and early 2018, but the correction last year – many S&P stocks fell 20 per cent or more from their recent highs – took away some of that frothiness. Right now, the S&P 500 has a ratio of 17 versus the average of 20.2 based on last year’s average earnings per share.

Value-oriented investors have traditionally relied on measures such as the P/E ratio to find hidden gems, but of course it doesn’t really work with every stock. High-flying young technology companies, with strong growth prospects but low to no profit, don’t fit neatly into this category. Neither do companies that have unusual gains or losses in a given quarter. A mature company with slowly growing profit is easier to measure this way.

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There are other ways to gauge whether stocks are overpriced or cheap. Warren Buffett, the champion of the value investing model, has talked about the ratio of market capitalization to national economic output, a very broad measure of where stocks are valued.

A high ratio would have the stock market valued well above the amount of goods and services produced. A country’s economy should be more in line with the earnings of the companies producing the services and goods.

Two times in the recent past, Mr. Buffett has noted, this ratio has gotten out of proportion – during the dot-com bubble of the late 1990s and in the time leading up to the financial crisis a decade ago. As of late December, analysts were modelling this ratio around 140 per cent, if the top number were the Wilshire 5000 index and the bottom were U.S. third-quarter GNP. That means stocks were overvalued.

Another valuation measure is the ratio of stock price to book value, which represents the value of the assets that would be left over if the company ceased to exist. A lower ratio could signal the stock is a bargain. It could also mean there’s something fundamentally wrong with the company.

Again, this measure isn’t good for every company stock. It can take the place of a P/E ratio when a company has a positive book value but negative earnings. But it isn’t useful for valuing tech or other companies with a lot of intangible assets. The current U.S. price-to-book is 2.3 compared with the average 2.4 and the historical high, in 2015, of 2.9.

Finally, there is price to free cash flow, which measures the money a company has generated after expenses and capital spending. A lower ratio is attractive for value investors especially if the value is improving over time. That means the company is growing. By this measure, stocks are at 11.8, which is also below the average of 12.8.

Mr. Buffett has said, “Price is what you pay, value is what you get.” Using some of the most common ways to evaluate a company’s stock relative to its value can help investors sort through the clutter to find a good bargain. Here are three stocks that score well on the models Validea has created to track the investment strategies of some of Wall Street’s top value investors. All of the stocks below get at least 80 per cent from two of more models.

FujiFilm Holdings Corp. (FUJIY) – The photo imaging and device maker scores highly on the models tracking several gurus, largely because of its cheap valuation. The P/E ratio is 14 and price-to-book is 0.9.

Alliance Data Systems Corp. (ADS) – This marketing and loyalty services software provider has a relatively low P/E of 10.3 and has a projected annual return for the next decade of 18.9 per cent using my Buffett-based model.

Chicos FAS Inc. (CHS) – This women’s clothing retailer scores highly on the models tracking the style of Benjamin Graham, famed value investor, and others. It has a P/E of 12.2 and a price-to-book of 1.2, both considered reasonable by Mr. Graham’s standards.

Editor’s note: A previous version of this article misidentified a company. The company, ticker symbol ADS, is Alliance Data Systems Corp., not Automatic Data Systems Inc.

John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.