The market is always right – or is it? Stocks represent the future valuation of the underlying company. Valuations are dynamic and affected by various factors not related to the actual company performance. Many times, the markets will overlook stocks as they remain undervalued for long periods of time. Finding these undervalued stocks takes some legwork but the payoff can be exceptional. Here’s how to find them.
What is an Undervalued Stock?
An undervalued stock is perceived to be trading at a discount to its “true” value. In many cases, an undervalued stock is performing well below it’s peers, industry, sector and benchmark indexes. It can be perceived as “cheap”, for a reason. Stocks tend to be undervalued due to material changes or deficits in the underlying business operations such as high levels or debt, declining market share, negative growth, regulatory issues and lowered expectations. Undervalued stocks tend to be perceived by the market as having problems, sometimes unfairly.
The Subjective Nature of Value
Beauty is in the eye of the beholder. Two investors can see the same stock and have their own idea of whether it is overvalued or undervalued. The argument for either side can be that the market has yet to recognize the real value. Value is dynamic, never static. The market will determine the true value of a stock, but that value will not stay static. Stocks can remain undervalued or overvalued for years.
Quantifiable Metrics for Gauging Value
To apply a conventional method of valuation, you can use common valuation metrics for any stock and compare them to peers or against industry and sector averages. You can use any combination of the financial metrics for your analysis. Here’s some of the common criteria you can use to as premises to determine a stock is undervalued:
Low P/E Ratio
The price to earnings (P/E) ratio is one of the most commonly used quantifiable metrics to determine if a stock is overvalued or undervalued. The P/E is determined by dividing the stock price by its earnings. Keep in mind, the company needs to have net earnings (profits) in order to even have a P/E ratio. If a company is projecting profits, then a forward P/E can be attained based on future estimates. A low P/E ratio is one factor used to gauge an undervalued stock. Low or high P/E can be measured by compared to peer stocks or an industry average. For example, if XYZ has a P/E of 8 versus its top competitor with a P/E of 20, then it is comparatively undervalued. It’s prudent to compare to a number of competitors and even industry averages for the best comparisons. If the industry average P/E is 22, then XYZ is undervalued by P/E.
Low Price-to-Book Ratio
The price-to-book (P/B) ratio is calculated by dividing the price of the stock by its book value. This metric can be used when then company doesn’t have profits. The P/B ratio can then be compared to peer/competitor and industry averages to determine if it is low and undervalued.
High Dividend Yield
The dividend yield is calculated by the annual dividend amount divided by the stock price. Dividends are usually paid out (distributed) on a quarterly basis at the ex-dividend date for shareholders of record on a specified date. While a high dividend may seem like a bargain, keep in mind that the higher a dividend means the lower the underlying stock price. If the company is having cash flow problems, the risk of dividends being cut or halted rises. High dividend yields of double-digits not only tend to indicate potential undervalued conditions but also high risk stemming from major underlying problems.
This metric is used to determine the short-term operating liquidity of the underlying company, also referred to as working capital ratio. It’s calculated by dividing the current assets to its current liabilities. A good current ratio ranges from 1.2 to 2 indicating low debt and high cash flow but should be compared to the industry averages. Keep in mind, this ratio pertains to the company’s financial liquidity not the liquidity of its shares.
This financial metric is calculated by dividing the underlying company’s total liabilities by its shareholder equity. Generally, a good debt-to-equity (D/E) ratio should remain under 2, but certain industries generally have higher average D/E ratios.
How to Find Undervalued Stocks
There are many ways to find undervalued stocks based on the financial metrics. Below are three steps to take.
Step 1: Build a Screen/Scan
- If your trading broker doesn’t have a scanner/screen, you can utilize many free scanners or take free trials and let the algorithms handle the legwork. Free tools like www.FinViz.com provide both fundamental and technical scanners that can be configurable to your needs.
- For the fundamental inputs, select a combination of the aforementioned financial metrics. (IE: P/E less than 10, P/B less than 3 and Current Ratio less than 2
- To tighten the filters, you can add some technical metrics as well (IE: Daily MACD under 30, Stock price less than 10% near 52-week lows
Step 2: Create a Broad List of Candidates
As you compile stocks that meet your criteria, make sure to start with a broad list and methodically trim the list down to a manageable number (EG: From 20 to 5)
Step 3: Research Further
As you thin out your list to the best qualified candidates in terms of both fundamental undervaluation and technical oversold levels, prepare to continue researching the individual stocks. Compare them to several peer/competitor stocks both financially and technically (IE: Lower P/E than competitors, MACD under 30/Stochastic under 20-band).
Researching Undervalued Stocks
This is where the real legwork comes into play. After your have filtered and narrowed your hunt down to less than a handful of stocks, it’s time to delve deeper. Keep in mind, there is usually many reasons why a stock is undervalued. There are problems or perceived problems with the narrative which is causing the market to discount these stocks. Just because the price is low, doesn’t automatically qualify it as an undervalued.
Look at the Company’s Financial Statements
Use your broker’s research tools or free tools like Yahoo Finance to access the most recent Balance Sheet, Cash Flow Statement and Income Statement. You can utilize the “statistics” tab on Yahoo! Finance for these. It’s also helpful to review how the latest earnings report fared against analyst estimates and if the company raised or lower their forward guidance. The reaction can be gauged on a stock chart.
Combine Metrics and Look for “Red Flags”
Keep in mind that having one financial metric or category appear undervalued, doesn’t mean the company is undervalued overall. For example, a company’s low P/B doesn’t help if earnings are declining sequentially. Or a low P/E doesn’t help if the company is losing market share. A strong spike in the earnings resulting from one-time events like a tax refund can be a red flag.
Look for Significant News
This is one of the main factors for stock prices to collapse. The most material news will be the quarterly earnings reports and the conference call transcripts. If the company missed earnings estimates and or guided forward earnings and revenues lower, then it may not be very undervalued. If the company reported strong earnings and/or raised earnings estimates but the stock sold off, then it could be an undervalued stock depending on whether expectations were too high, or a sell-the-news reaction happened.
Ask WHY a Company is Undervalued
This is the goal of the research. Determining whether the negative sentiment is a result of a misguided narrative. Find the obvious reasons why the company shares are undervalued, then determine if the reasons are true or lasting. Has the company sold off its most profitable divisions leaving only the market share losing legacy products? Or perhaps, the company is losing market share now, but transforming its revenue model from a product to a subscription model to improve cash flow forecasts and bolster client retention and growth? Play both sides of the argument and be objective.
Tips for Investing in Undervalued Stocks
Often, investing in undervalued stocks mean you’re taking the other side of the negative sentiment and may continue to incur more losses until the fundamentals turnaround. Here’s some tips to keep in mind.
Being ahead of the market takes conviction and most importantly patience. It can take time for the market to share your perspective, but if your research is solid, it may be just a matter of time. Also considering scaling into a position rather than take one entry. This will help you practice patience and possible get a better average price.
Be Aware of Current Investing Trends
Make sure that you are familiar with the current investing themes and trends. The market may be chasing hot momentum driven theme like electronic vehicles and e-commerce stocks while ignoring value stocks. The market may return to value in time, but there is no guarantee. For quicker results, it may be prudent to research undervalued stocks within the current momentum themes.
Don’t Get Too Attached to the Concept of Value
There is a fine line between conviction and stubbornness. If your research is proven wrong or lacking, then don’t hesitate to take a stop-loss and reevaluate or move on. Never get married to a stock that’s “cheap” while the reasons for getting cheaper remain valid. Have a stop-loss set and have the discipline to execute it. Remember, you can always buy back into the stock when the fundamentals and/or technicals improve.