How to Find Undervalued Stocks: An Ultimate Guide
It’s human nature to love discounts: we love to buy things when they are underpriced and make the most value of them. This is true in all kinds of things, expensive or otherwise, and the same behavior is also prevalent in investing.
In fact, the most basic principle of investing, including stock investing, is to buy at a low price and sell at the highest value possible to make the most profits.
This is why many investors spend their time looking out for undervalued stocks, both to reduce the risks of the investment and to maximize their potential reward.
In this guide, we will discuss all you need to know about how to determine if a stock is undervalued, and by the end of this guide, you will have learned about:
- What is an undervalued stock?
- Different stock selection criteria one can use to determine whether a stock is currently undervalued
- Fundamental stock analysis and technical analysis techniques to find undervalued stocks
- Using the help of stock picking services
- Do’s and don’ts of purchasing stocks to maximize value
What Is an Undervalued Stock?
An undervalued stock is a stock that—according to you, based on assumption, analysis, or other methods— is currently priced on the stock market lower than its true (intrinsic) value.
For instance, let’s say Amazon’s stock is currently priced at $100 per share on the stock market, but you think that it should be worth $150. In this case, Amazon’s stock is assumed to be currently undervalued.
The assumption is the keyword there, since different investors and different “experts” may use different criteria to determine whether a stock is undervalued, fairly valued, or overvalued. These criteria can be based on many different things: the company’s financial performance, current stock market trends, and other data.
This guide will be focused on discussing these different criteria and an analytical framework on how to identify these undervalued stocks.
Value Investing and Undervalued Stocks
Why do investors look for undervalued stocks in the first place? The answer is an investing methodology called value investing.
Value investing was introduced by none other than Benjamin Graham, a famous 20th-century investor. Value investing is also practiced by Warren Buffet, considered by many to be the world’s greatest value investor. This method focuses on purchasing undervalued stocks and then selling those stocks when they are fairly priced (or, even better, when they are above the computed intrinsic value at the time of purchase).
In most cases, however, it can take months and even years before an undervalued stock reaches its fair price range (and there are also cases that the price never actually goes up). So, value investing is more suited for patient investors who’d like to invest long term.
The key to the value investing strategy is properly identifying undervalued stocks, which is typically performed via top-down analysis. To really understand top-down analysis, we must first understand that there are two basic approaches used for analyzing stocks: bottom-up and top-down.
Two Basic Methodologies for Analyzing Stocks
Before we dive further into finding undervalued stocks, we must understand that there are two basic methodologies for analyzing stocks.
All other stock selection techniques and methods are derived from these two approaches:
- Top-Down Analysis Methodology
In this investing analysis approach, the investor or expert starts the analysis by looking at the overall economic situation (the top) like the country’s monetary policy, inflation, economic growth, and so on. Then, the investor will analyze the sector/industry the target company is in before finally analyzing the individual company.
With a top-down approach, the investor or expert will first look for macroeconomic and/or sectoral factors and try to identify opportunities from those factors. For example, the global COVID-19 pandemic was a major macroeconomic factor to consider throughout 2020 and 2021, and there were numerous investment opportunities that arose from it (e.g., Zoom at the early days of the pandemic).
In many cases, top-down investors are more focused on capitalizing on larger trends than individual stocks, so the strategies derived from this approach are typically more focused on trying to get short-term gains rather than using a more value-based analytical framework to identify undervalued companies.
- Bottom-Up Analysis Methodology
With a bottom-up approach, the investor or expert starts the analysis process by first looking at target companies (individual stocks), analyzing the attributes of each stock and especially the microeconomic factors surrounding the stock.
The bottom-up analysis methodology is the one focused on finding undervalued companies based on various stock selection criteria (which will be discussed further below in this guide).
The bottom-up analysis methodology is more focused on long-term investing (buy-and-hold). Investors/experts employing a bottom-up methodology tend to invest more time in researching individual stocks before making an investment decision.
Investments made with a bottom-up approach may take a longer time to be profitable, but the risks associated with the investment may be more manageable. This type of investment is less likely to be affected by macroeconomic factors, hence the lower risks.
Popular Stock Selection Criteria
In this section, we will discuss two popular stock selection criteria created by two famous investors: Benjamin Graham—considered by many to be the pioneer of value-based investing with his book The Intelligent Investor— and another one by the famous investor Warren Buffet of Berkshire Hathaway.
Benjamin Graham’s Stock Selection Criteria
Benjamin Graham’s stock selection criteria are among the oldest methodologies available to identify whether a stock is currently undervalued
Here are some of the most important criteria used in Benjamin Graham’s methodology:
- Stock price:
- Should be less than two-thirds of Net Current Assets
- Should be less than two-thirds of Book Value (Book Value refers to the net difference between total assets and total liabilities)
- Price-To-Earnings (P/E) Ratio
- Should be lower than 40% of average P/E ratio for the last 5 years
- Should be lower than the inverse yield of AAA corporate bonds
- Dividend Yield: more than two-thirds of AAA Corporate Bond yield
- Current Assets: more than double the company’s current liabilities
- Debt/Equity Ratio: less than 1 (equity should always be higher than debt)
- Outstanding Debt: less than 2 times of Current Assets
- Earnings: only 2 years of negative earnings are allowed
- Earnings per Share: should grow more than 7% over the past 10 years
While Benjamin Graham’s stock selection methodology is old and has been widely used since the 1940s and even the late 1930s, that doesn’t mean it’s obsolete. One can still use these criteria as a solid foundation in finding undervalued stocks, although one can add more modern criteria to improve accuracy.
Warren Buffet’s methodology is newer with more modern principles involving analysis of qualitative factors which we will discuss below.
Warren Buffet’s Stock Selection Criteria
Warren Buffet’s stock selection methodology is based on the qualitative evaluation of four key areas: Business, Management, Financial, and Market. Below is the breakdown of Warren Buffet’s stock selection criteria:
- Business:
- The business model must be simple and understandable
- Has favorable long-term prospects
- Presence of economic moat (basically, the company’s unique and clear advantage over its competitors)
- Favorable long-term business prospects
- Management:
- Honest and open leadership
- The company is a leader, not a follower in its industry
- Financial:
- Use of discounted cash flow
- High earnings
- High return on equity
- Stable and high margin of profits
- Market
- Greed and fear among investors (in buying the stock)
- Use of conservative earnings estimates
Warren Buffet’s investing lessons have also showcased how qualitative principles (common sense), and not only quantitative metrics, can help us identify undervalued stocks to allow profitable, low-risk investments.
Fundamental Analysis to Identify Undervalued Stocks
Fundamental analysis refers to the analysis of financial metrics to determine the value of a stock (and whether it is currently undervalued, overvalued, or fairly valued). Here are some of the most common and important fundamental analysis techniques used in determining the value of stocks:
Price-To-Earnings (P/E) Ratio
A common metric used to determine a stock’s relative value (although it’s not the most accurate). The lower the P/E ratio of a company, the lower the price of the stock relative to the company’s profit.
Thus, a low P/E ratio may be a sign that the stock is currently undervalued. However, it’s crucial to understand the basis for the low P/E. For example, the company might not have an exciting long-term growth opportunity, so investors won’t pay a premium multiple for low growth. Alternatively, there might be an impending shift in the business cycle and analysts have yet to cut their earnings estimates for the stock.
Price-To-Earnings Growth (PEG) Ratio
A low Price-To-Earnings Growth (PEG) ratio is considered a strong sign for undervalued stocks, and PEG is also considered more accurate than the P/E ratio. The PEG ratio is essentially the P/E ratio divided by the company’s expected rate of growth.
For example, if the company’s P/E ratio is 10 and the stock has a projected earnings growth rate of 20%, the PEG ratio is 0.5. The lower the PEG ratio, the higher the company’s potential for growth, signifying that the stock may be currently undervalued.
Discounted Cash Flow
Projecting a company’s future cash flows and analyzing these projections to determine the company’s current true value. This is a very popular form of fundamental analysis that can be used to determine the intrinsic value of a stock
Dividend Discount Analysis Model
This analysis model focuses on analyzing and comparing a target company’s current and projected dividend payments to determine the true value of a stock.
Price-to-Book Ratio
“Price” here refers to the company’s total market capitalization, while “book value” refers to total shareholder equity (assets minus liabilities = shareholder equity). A low Price-to-Book ratio may indicate that the stock is currently undervalued, although we’ll still need to identify the real value of the company’s tangible and intangible assets.
For example, a building property is considered a tangible asset, while intellectual property (like a film) is considered an intangible asset. In this case, a film production company may own a film intellectual property that is worth more than the building it owns.
When using this metric, investors should be careful in identifying the actual value of the company assets.
The Value Trap
Finding undervalued stocks to invest in would require enough experience and knowledge about the company itself, the industry it’s in, and the market itself. There are many cases when stocks can appear to be undervalued when it’s actually fairly priced, and vice versa.
This is known as the value trap.
For example, based on the fundamental analysis you’ve performed, a stock may have shown all the signs of an undervalued stock: low P/E and PEG ratios, low Price-to-Book ratio, and so on. However, after the stock is purchased, it doesn’t perform as the investor expects based on the analysis.
In a value trap situation, the stock is actually fairly priced (or in some cases, actually overvalued), although the signs pointed that the stock may be undervalued. Due to this fact, the stock’s value may not go up over time, and basically, the value investment fails. There’s also the possibility that the stock’s value declines so you may need to sell the stock at a loss.
Identifying Undervalued Stocks: Step-By-Step
While there are various methods you can use to determine the value of a stock and whether it’s currently undervalued, here we’ve designed a basic step-by-step guide you can use to select undervalued stocks.
Step 1: Narrowing Down the Selection Pool
Before anything else, you should reduce the number of stocks you’ll analyze to save resources and time (and improve accuracy).
Eliminate companies that currently experience governance issues and a deviation between profits and cash flows.
Then, analyze the earnings quality of the company (how well the company’s current earnings can predict the company’s future. There are many ways to analyze earnings quality or Quality of Earnings (QoE), but the most common indicators are:
- Inconsistencies and deviations between cash flow and profits (i.e., frequent related-party transactions)
- A high percentage of promoter shares pledged. The smaller the quantity of promoter-held shares being pledged, the better.
- Inconsistent dividend payments
- Inability to deliver results on time to shareholders
- Unstable earnings ratio (PE ratio, one-off charges, etc.)
- Irregular depreciation charges
The basic idea is to eliminate companies that manipulate their accounts in one way or another, have cash flows that don’t reach investors and have complex balance sheets in general.
Obviously, you can use other criteria of elimination depending on the target stocks and other factors. The purpose of this step is to reduce the number of available investment options to ensure the next steps are more manageable.
Step 2: Evaluating Quality Stocks
Now that you’ve reduced the list of stocks to analyze, the next step is to analyze the remaining stocks and select the best investment opportunities.
We can use various methodologies and criteria here, as we’ve discussed above, but here are some common metrics and ratios you can focus on:
1. Current Ratio
The Current Ratio refers to the ratio between the company’s current assets and current liabilities, so to get this number you simply divide the company’s assets by its liabilities. This ratio is useful to measure the company’s financial health and to determine whether the company can pay its debt obligations.
2. Price-to-Earnings Ratio (P/E)
Discussed above, the P/E ratio can be calculated by dividing the company’s current share price and its earnings per share. On the other hand, you can calculate the company’s earnings per share by dividing a company’s profit by the number of outstanding shares pledged.
The lower the P/E ratio is, the stronger the sign that the stock could be currently undervalued.
3. Price-to-Earnings Growth Ratio (PEG)
To calculate PEG, simply divide the P/E ratio by its earnings growth rate.
A low PEG ratio is a strong indicator that the market is currently underestimating the company’s potential to grow, and so the stock is potentially undervalued.
4. Return on Equity (ROE)
A high ROE over the long term is a strong sign that the company uses its available capital effectively to grow. Thus, the higher the company’s ROE, 15% or higher in the long term, the better and healthier the company’s performance is.
You can calculate ROE with the following formula:
ROE= {Revenues – (Expenses + Tax)} / {(Average Assets) – (Average Liabilities)}
A high ROE will also translate into a better Quality of Earnings (QoE), which is also an important metric to determine whether a stock is currently undervalued.
5. Price-to-Book Ratio (P/B)
You can calculate the Price-to-Book ratio by dividing a stock’s current market price by its equity per share. A P/B ratio that is less than one may be a sign of an undervalued stock since it suggests that the share is currently trading below the intrinsic value of its assets.
6. Debt-to-Equity Ratio (D/E)
D/E ratio will help measure how reliant the company is on debt when compared to equity to finance its operations.
The Debt-to-Equity ratio can be calculated by dividing the amount of debt the company currently has, and you can calculate it by dividing the total amount of debt of the company by its shareholders’ equity.
Step 3: Analyze Dividend Yield and Cash Flow
If the company pays dividends, then you should also analyze the company’s dividend yield, as well as its current cash flow to validate whether the stock is indeed undervalued.
A high dividend yield suggests that the company is profitable, but the company’s cash flow (and other metrics like debt payment history) will determine whether this dividend yield is sustainable.
When trying to find undervalued stocks, you should look for stocks with a consistent dividend yield and cash flow. A company that consistently and regularly pays out its dividend despite a fairly low share price is a sign that the stock could be currently undervalued.
Step 4: Analyze the Financials
The better you understand the company’s financials by reviewing items like the income statement, balance sheet, and cash flow statement, the better you can understand the company’s financial performance and whether its performance is sustainable.
In general, you should look for companies with steady and consistent (or better, growing) financial performances with minimal debt, and yet the stock price isn’t increasing. This is a strong indicator that the stock’s potential hasn’t been recognized by other investors, causing its undervalued state.
However, the company’s financial position is always relative to its competitors, as we’ll discuss in the next step.
Step 5: Analyze Competitors
Another basic way to identify whether a stock is currently undervalued is to look at other companies in the same sector.
If you think a stock is currently undervalued, analyze other similar companies that sell at a higher price, and analyze what causes the stock’s price to be lower than its competitors. You should also validate whether these competitor companies are currently accurately valued (it’s possible that they are currently overvalued) to prevent a value trap.
Step 6: Analyze Price-to-Book Ratio
In value investing, it’s crucial to make sure not to overpay for an undervalued stock, even if all indicators have suggested that the company is well-managed and is currently undervalued. If the stock’s price is still currently too high, it might not be a good value investment.
In general, the company’s Price-to-Book (P/B) ratio shouldn’t be higher than 1.5 times the average P/B ratio of the sector, or else it may be currently overvalued. So, it’s important to first identify the average P/B ratio of the sector/industry, which can vary a lot between different sectors.
Ensuring the stock has a low P/B ratio relative to its sector can help you easily identify undervalued stocks.
Conclusion
Accurately identifying undervalued stocks and value investing opportunities can be easier said than done, or else everyone would be doing it right away.
Patience and careful analysis remain the most important keys to success if you want to invest in undervalued stocks. The better you understand how to identify stocks that may be undervalued (as we’ve discussed in this guide), the easier it will be for you to use a value investing strategy to manage risks and maximize profitability.
