An undervalued stock is defined as a stock that is trading below its underlying (i.e. intrinsic) value. Undervalued stocks are sought after by value investors. Investing in undervalued stocks requires understanding why a stock is trading below its underlying value.
In this article, we’ll help investors understand why a stock would be trading below its real value, how investors can use publicly available data from companies to identify undervalued stocks. We’ll also address why the internet is making it easier than ever for investors to find undervalued stocks and how investors can go beyond the numbers to find stocks that are undervalued.
Why Undervalued Stocks Are Important to Value Investors
Value investing is an investment strategy that involves picking stocks of companies that for one reason or another are trading at or below its intrinsic value (otherwise called its book value). This particular strategy of finding undervalued stocks dates back to 1949. That was the year Benjamin Graham published The Intelligent Investor.
Value investing is the opposite of growth investing. This involves buying stocks that are outperforming the market regardless of their valuation. Often these are stocks that grab the headlines in the mainstream financial media.
Value investing tends to move in and out of fashion along with the economy. When the economy is going well, many investors tend to look for growth stocks. But when the economy shows weakness, value investing becomes the goal of many investors.
Why Would a Stock Trade Below its Real Value?
The conventional wisdom is that when a company’s stock is falling, there is a distinct reason to stay away. But that may not be the case at all. A key principle of value investing is understanding why the market price of a stock is not always accurate. There are several reasons this may occur:
- A company’s earnings report misses expectations - Corporate earnings reports are one of the most closely watched metrics for investors. Publicly traded companies are required to present investors with detailed financial statements that provide a snapshot of the quarter just completed and guidance for future quarters.
If a company delivers results that are below the expectations of the analysts that cover the company (e.g. have lower revenue and/or earnings per share than expected) shares of the company’s stock may drop lower than the company’s fundamentals suggest should be the case.
- The broader market crashes or corrects - When there is a broad sell-off based on a significant event (e.g. the coronavirus pandemic) it doesn’t discriminate which stocks see their share prices fall. This can be an exceptional time to find stocks of quality companies at bargain prices.
- A specific company is hit with bad news - From a product recall to a food safety issue, a company or sector can get hit with bad headlines. However, this can lead to a disproportionate response that can take a company’s shares further down than is warranted.
- Normal fluctuations in the business cycle - Different sectors of the economy perform better at different times of an economic cycle. When a sector is out of favor, it can be a good time to look at finding a quality company selling at a price below its underlying value.
How Can Investors Identify Undervalued Stocks?
Value investors use a variety of tools to actively look for stocks that may be being disregarded. One of the principals of value investing is that institutional investors and analysts overreact to the news. When this happens, it’s possible for a stock to get decoupled from its fundamentals. This can cause a stock’s price to drop lower than the company’s book value and the stock can become undervalued.
The good news for investors is that there are a variety of online tools such as stock screeners that make it easy to find undervalued stocks. But investors can also look beyond the numbers to see if a company is undervalued. For example, a company that has a proprietary formula or manufacturing process may have a unique selling proposition that allows it to offer consumers lower prices.
Here are six common criteria that value investors will use to identify undervalued stocks:
- Stocks that have a low price/earnings (P/E) ratio – A stock’s price/earnings ratio indicates how much investors are willing to pay for a dollar of earnings. The price/earnings ratio is calculated by dividing a stock’s current price by its annual earnings. A lower P/E means a stock is technically “cheaper”. It is important to interpret an individual stock’s P/E ratio in context with other companies in its sector.
- Lagging relative price performance – Just as you can compare P/E ratios between companies in a sector, you can also compare share price. If a particular company has a share price that is lower than its peers, it can be an indication of a stock that is undervalued.
- Stocks that have a low price/earnings to growth ratio – A company’s price-to-earnings to growth ratio (also referred to as its PEG ratio) is found by dividing a stock’s P/E ratio by its projected earnings growth rate over a certain time period. The typical time frame is five years.
A ratio of less than 1 may indicate that investors are giving more weight to past performance than to future growth opportunities. The PEG ratio can also help investors identify companies that have a relatively high P/E ratio but support that with rapidly growing earnings. This says that the company is generating both sales and profit.
- Stocks that are offering a high dividend yield – A high dividend yield is one of the more deceptive ways to look at a stock. As a company’s stock price goes down its dividend yield goes up.
To be fair, a company that has a high dividend yield may have that because it is in financial trouble, but often it is simply a victim of temporary circumstances. If the fundamentals of the company look good, and it does not appear they will have trouble paying its dividend, then buying these stocks can provide a high dividend in the short term, and the potential for nice growth in the longer term.
- Stocks that have a low market-to-book ratio – A company’s market value is its total market capitalization (market cap). A company’s book value is the net asset value (NAV) of a company. To calculate book value, subtract a company’s liabilities from its assets. Then divide that result by the number of common shares outstanding. Investors that are using this metric should pay attention to is the real value of a company’s tangible assets and its intangible assets.
- Free cash flow – Free cash flow is the cash that a company generates after it accounts for cash outflows to support operations and maintain its capital assets. It is a measure of profitability. If a company is reporting lower earnings but a high free cash flow it can mean the company is undervalued. However, it can also be deceptive because it may mean a company is not making the best use of the cash they have on hand.
How Can Investors Determine the Value of a Company?
One of the many reasons that the internet has made this a golden age for investors is that investors have more access to information than they’ve ever had. The Securities & Exchange Commission (SEC) requires companies to file their financial information prior to their earnings reports. These basic documents such as a company’s income statement, balance sheet, and cash flow statements are available on a company’s web site.
Here are a few other metrics you can use to evaluate the value of a stock.
- Price-to-book (P/B) ratio – This is a stock’s price divided by its equity per share. A book value of less than one suggests that a stock is trading for less than the value of the underlying company’s assets. Value investors use P/B multiples to find stocks with a margin of safety.
- Return on equity (ROE) – This is a company’s annualized net income as a percentage of shareholder’s equity. ROE measures how efficiently a company uses its invested capital to generate profits.
- Debt-to-equity ratio – This is a company’s total debt divided by its shareholders’ equity.
- Current ratio – This is a ratio that expresses how easily a company can pay its short-term obligations. Current ratio is calculated by dividing a company’s current assets by its current liabilities.
There are also a variety of stock screening tools that automatically perform these calculations such as the ones listed above. Many of these stock screeners allow you to sort companies by specific metrics so investors can easily find companies that meet the criteria that they determine.
What Are Other Ways Investors Can Look for Undervalued Stocks?
Before you start to look at the financials of specific companies, you have to narrow down your target list. Here are some guidelines to follow.
- Investors should look at companies they understand – This would seem fairly obvious, but many novice investors make the mistake of investing in companies that they don’t understand. For example, in the dot-com boom many investors were buying shares of companies simply because they had a .com in their name. But the internet in general was a new phenomenon and many investors did not realize that many of these businesses had flawed business models. Sticking with businesses that they know can help investors understand what the company’s numbers actually mean.
- Look beyond a company’s numbers when necessary – You sometimes hear about a company having a “moat”. This simply means that its business is protected, to a certain extent, from competition. A good example of this is a company like Walmart which based on its size and efficiency can simply keep prices lower than many other retailers. Companies with a moat tend to perform well in tough economic times because customers will seek out their business for lower prices.
This also applies to companies that provide the goods and services that are stocked inside a Walmart. You hear the words “defensive stocks”. These are companies that make products that consumers need regardless of the state of the economy.
Some Final Thoughts on Undervalued Stocks
Finding undervalued stocks is not an exact science. Value investing in general frequently goes out of fashion when the economy is good. When the market is rising, it’s easy for investors to lose sight of their investment objectives and even their risk tolerance as they try to chase after the highest flying stocks.
Unfortunately, as we’ve seen many times, when the market goes down there is a flight to safety and quality. At times like these, investors take a closer look at the merits of value investing. One of the most difficult things for investors to see is that there are well-performing stocks in any economy. One of the keys for investors is not only staying engaged in the market, but also to look for undervalued stocks that can help their portfolio regardless of what direction the market is moving.
