Identifying cheap stocks – companies that trade below their true value – has been the primary focus of hedge funds, legendary investors like Warren Buffett, as well as traders and retail investors.
But finding quality undervalued stocks and buying them in the hope of trading them later at fair value requires some knowledge.
What are Undervalued Stocks?
According to value investors, undervalued stocks can be found under any market conditions. These investors believe that the stock market is not always efficient at pricing stocks and that fundamentally sound stocks trade at an undervalued price at any given time.
In the long run, it is believed the market for these securities will correct, sending the stock price up to its appropriate value and earning the savvy value investor a significant profit in the process.
It is not uncommon for a company to show earnings and income growth for several years with strong demand for its goods and services while being largely ignored by Wall Street.
Undervalued stocks are selling at significant discounts to their intrinsic values – that is, the net present value of the stock, given the expected growth rate of the company. The difficulty, of course, is in determining what the “true” value of the stock actually is.
A rule of thumb for value investors is to look for an excellent stock at a good price rather than a dirt-cheap stock of a company with weak fundamentals and growth expectations. The stock of an excellent company is far more likely to return to favor and bounce back.
Using a Stock Screener to Find Undervalued Stocks
What you should looking for while using a stock screener:
- Low P/E (Price/Earnings) Ratio – This very important valuation ratio of a company’s current share price compared to its earnings per share. This measure is most useful when compared with other companies within its industry. The P/E ratio indicates how much you are willing to pay for each dollar of earnings. By definition, then, with a low P/E ratio, you are getting these earnings for less.
- Low PEG (Price/Earnings to Growth) Ratio – The PEG Ratio compares the stock’s P/E ratio to the expected annual earnings per share (EPS) growth. It is believed that a fairly-priced stock will have a PEG ratio of 1. It follows then that an undervalued stock will have a PEG ratio of less than one. Very good value is generally believed to be at a PEG ratio of .5 or less.
- Low Debt to Equity Ratio – This ratio is used to measure a company’s financial leverage. A high debt/equity ratio can signal that a company is over-leveraged, possibly financing its growth through the acquisition of debt. The resulting additional interest expense can create a real burden for the company.
- High Net Profit Margin – A high net profit margin indicates that the company has control of its costs, an indication of strong management. Like the P/E ratio, it is best to compare profit margins within industries.
- Low Trading Volume – The idea here is that stocks with high trading volumes are on the radar of institutional investors, making them less likely to remain undervalued.
Finding Good Stocks to Buy – Five Things to Look For
Stock market investors are trying to find good stocks to buy before the other stock market investors find them. Given the laws of supply and demand that apply to the stock market, which is a very efficient market, you want to buy undervalued stocks. Ideally, the demand for these stocks will increase after you have purchased.
Essentials You Need to Know About Every Stock You Buy
Strong Earnings Growth – Earnings are the reason the business exists and are typically the most important drivers of a stock’s price. Defined as the company’s revenues, less its cost of sales, operating expenses, and taxes, for a defined period, earnings indicate the future dividends investors can expect, its potential for growth and stock price appreciation.
If you were to research the historical relationship between earnings growth and stock price appreciation, you would find a strong positive correlation.
Market Leadership – Those companies with the largest market share in their respective industries- may have achieved price control and significant advantages with regards to economies of scale, production, and delivery.
These companies have often created an advantage for themselves that they can enjoy for years to come.
Steady/ Increasing Return-on-Equity (ROE) – One of the most important profitability metrics, the ROE measures a corporation’s profitability to reveal how much profit it generates with the money invested by shareholders.
As companies earn money, it is paid out to shareholders or it goes into retained earnings for the company. Strong, consistent ROE demonstrates sound financial health.
Solid/ Improving Productivity – Productivity measures vary from industry to industry. Manufacturers, for example, will look to increase the volume of the product they are producing while minimizing production costs. Across industries, though, companies will look to generate more sales and profits for the assets they employ.
An indicator of how profitable a company is relative to its total assets. The return-on-assets (ROA) offers an indication of how efficient the company is in using its assets to generate earnings.
Good Value – Valuation is the investor’s attempt to determine the worth of a share-based on company fundamentals. Value investing is about finding stocks that the market has not correctly priced as their perceived, “intrinsic” value is greater than the current market price.
If the company’s fundamentals are sound, but the stock’s price is below its value, you may have found a good investment candidate.
Finding Undervalued Stocks Opportunities
The Stock market operates on a herd mentality. When the herd thinks a stock will go up, buyers bid it up, when the herd decides a stock is too high they trend of the stock reverses.
The underlying fundamentals figure into it but a stock representing a company with good financial numbers can trend down simply because the price is considered too high.
Many times the yardstick used to determine the “correct price” for equity is the Price/Earnings Ratio (P/E) as compared to the other companies in the same industry.
Quite simply, you can assume that stocks that are trading at a P/E that is low compared to others in its industry “should” go up to at least reach the industry P/E average. If they haven’t reached that point yet we can consider them to be cheap stocks.
Internationally, the choice is nearly infinite. How can you manage it, to find the best and the cheapest stocks out of this huge number of possibilities? Let’s look at some possible ways, to find cheap stocks, together with their pros and cons.
The undervalued stocks are among the best forms of investment on the market today
Normally, the concept of a stock involves large companies selling partial ownership and control to people in exchange for pieces of paper called stocks that come with voting rights. More so, the stock comes with monetary returns at the end of every financial period called the dividend.
These shares can also be sold from one investor to another with people preferring to sell them when they have appreciated or when they suspect that their value is about to fall. Different companies’ stocks are of different values. Some stocks cost less and therefore have lower dividends and are undesirable. Others cost more and have higher returns.
However, there are some which, for a short period, will cost less, but they are valuable. When other investors discover this, these undervalued stocks then shoot up and those who bought them at a lower price can sell them at a higher amount. Explained here are some criteria with which to identify these stocks.
The first thing to do is to look at the size of the company. It is important to consider companies whose capital investment is between $250 million and $1 billion.
These companies are neither small nor are they large. Financial history has shown that these companies have the greatest potential to take off more than any other category of firms. However, this is not a foolproof method for finding undervalued stocks. Some of these companies may end up making losses and thus have the value of their stocks get lower, but it is a great starting point.
Companies with a low beta ratio preferably less than 1.0 are ideal as compared to those with a higher one. This ratio measures how sensitive a company’s returns are to the market returns. Theoretically, a stock that has its returns varying less than those of the market has a less than 1.0 beta value. This makes it less risky and volatile to market changes.
The other factor that is becoming increasingly important in rightly identifying undervalued stocks is whether the company is global or not. In recent years, America’s economic might has been undermined by many emerging economies such as China.
This means that in the event of an economic shock like the one experienced in 2002, there is a very high chance that if the company’s main market is American, it is likely to suffer.
However, if the market is international, then the moment the American market suffers, it can always depend on other markets around the world to supplement that which has been lost in America.
The other way of finding undervalued stocks is to look at a company’s financial performance history. Pick a company that has shown consistent growth over the past five years.
The continuous growth of approximately 10 percent per year is a good indicator. This percentage should cover the following parameters – ROIC (Returns on capital invested), EPS (Earnings per share), free cash flow, sales and BVPS (book value per share).
Use a Stock Screener
And you must not do it all at once. Look at one, two or maybe ten companies per day. For years, this will add up to a really large number and an ever-increasing circle of competence. You will acquire a basic knowledge of a huge number of companies. That can’t be a bad thing.
There are many finance websites out there, (like Yahoo Finance or TradingView) that provide stock screeners, which enable you to search stocks meeting various criteria. For example a P/E or a P/B ratio below a certain threshold.
I am primarily interested in small and tiny stocks. Most stock screeners have no or often faulty data for them. For US-stocks the situation shall be a bit better, but I’m not actively searching there at the moment.
The second problem is: if you screen for low-priced stocks, you have to know in detail what to screen for. But undervaluations of stocks can appear in many forms. There are often obscure things, you didn’t expect before. If you look at a company and think about it, you may discover that fast.
The human brain is built to deal with things yet unknown, computers are not. So you are in danger to miss some really interesting things if you only rely on stock screeners.
But despite all these problems: stock screeners are a good possibility, to generate some interesting candidates for undervalued stocks.
- Finding Stocks to Buy and Hold
- The Importance of Revenue Growth in Stock Investing
How to Find Undervalued Stocks – Stock Market for Beginners
Look at The Losers
It is the psyche of the human being to extrapolate good as well as bad things long into the future than they may last. Humans tend to be over-optimistic and over pessimistic.
So you might take advantage of that fact. The stock price of companies facing difficult times goes down. And it is not uncommon that it goes down further than the long term economic outlook for the company declines.
But watch out: a sharp fall of a stock price does not necessarily mean that a stock is undervalued. It can only be seen as a hint, that the chance of an undervaluation might be higher than normal and that it may be worth having a closer look at this company.