When you buy a stock, it is important to ensure it gives you the best return on investment possible. And that is where the concept of overvaluation and undervaluation of stocks comes in.
Overvalued stocks are way too common out there because they are the ones that get media coverage and almost all stock gurus recommend them. Undervalued stocks, on the other hand, barely get the attention they deserve meaning you have to dig for them.
Many a time, those who opt for the easy way out and chase the popular stocks tend to burn their fingers in the long run.
If you are a small investor looking to make the most of your investment in stocks, it’s advisable to learn how to identify undervalued stocks.
Why Finding Undervalued Stocks Is Important
First off, don’t mistake undervalued stocks for cheap ones. A stock is considered undervalued when its price underestimates the true value of the company i.e., its prospects, competitive edge, and revenue stream.
One benefit of buying stocks from undervalued companies is that it provides you with an enhanced potential to earn profits. Note that, a company might be undervalued today e.g. because people are yet to understand its product's usefulness. However, once the company manages to prove its worth, its stock is likely to blow out of proportion and literally make you rich overnight.
That's exactly what the people who identified Apple Inc and Facebook in their infancy did. They saw the potential before the rest of the world could. And just like that, they saw the value of their investments in those companies rise steadily over time.
And the good news is you also can do that. And although finding a valuable stock is not always easy, we've got some handy tips that can help you in that mission.
How to Identify Undervalued Stocks
Finding an undervalued stock is often not a walk in the park. If it was easy, everybody could be doing it (after all). The following is a breakdown of how to find undervalued stocks.
1. Start by Screening the Stocks
There are thousands of stocks on retail on various exchanges across the world at any given time. The NASDAQ composite index for instance is home to more than 3,700 listed stocks. What about the New York Stock Exchange? Well, the NYSE has more than 2,500 domestic and international companies on its listing.
So, as you can see, it's nearly impossible to screen all those companies manually. Luckily, digitalized screeners do exist and all you need to do is key in your search criteria in them – they'll automatically generate a list of stocks as per your requirements.
Here are some of the criteria you can use to single out potentially undervalued stocks even in vast marketplaces.
A good dividend yield is one that is greater than 1 percent (>1%). In fact, companies that post dividend yields of 2% to 4% are considered quite strong. However, anything above 4% might be a bit risky to buy.
Exceptionally high dividend yields can be a fool’s gold. In some cases, it could even indicate that a company is facing some kind of distress.
So, in your search criterion, you'll want to focus on companies whose dividend yield is above 1% but below 4%.
But this measure alone isn’t adequate. You have to weigh it alongside other factors as follows.
Remember, our core focus is on small companies that are barely receiving any attention for now even though they are of high potential. One way to narrow down on them is by screening them on the basis of market capitalization.
Generally, companies with a market cap of less than 1 Billion (< 1 Billion) are considered small-cap and, therefore, hardly ever attract the attention of the media and stock analysts.
You want to aim for a company with a current ratio that's more than 2 (>2). Such a current ratio is an indication that a company can easily meet its short-term obligations.
The reason why this measure is important is that it helps you assess the health of the company’s balance sheet.
In short, it gives you a rough idea of how a company's stocks stack up against its current liabilities. It also can tell you a lot about a company's liquidity.
A company with a current ratio below 1 (<1) is potentially at a high risk of defaulting in the short run and may require digging deeper into its pockets to survive.
But even then, a company with a current ratio that is extremely high e.g. >10 can easily be a fool’s gold because it might indicate that the company is not efficient at utilizing its resources.
Debt to Equity Ratio
A low debt to equity ratio always indicates that a company has a good degree of solvency. Therefore, you want to aim for companies with a <0.5 debt to equity ratio. A company that has good solvency is able to finance its growth using its internal capital.
While a high debt to equity ratio is not necessarily bad, companies with such are always the first ones to go under in times of economic meltdowns.
Low debt to equity ratio is important for guaranteeing you steady returns in the long run.
Another thing worth noting is that debt/equity ratio might vary from industry to industry. Some industries tend to put up with more debt than others as they are capital intensive. In that case, your best bet is to go for companies that are less leveraged than the industry’s average.
Return on Equity
A return on equity that’s greater than 10% confirms that the company is highly profitable and has a unique competitive edge. Of course, you want to buy stocks from companies that create profit, not ones that burn it.
A good ROE is also a good measure of how well a company is being managed. And going by that criterion, companies that earn more than 10 cents per dollar of equity are certainly worth adding to your profile.
Why Not to Use P/E As A Criterion to Find Undervalued Stocks
Some stock trading gurus recommend using price to equity ratio to locate undervalued stocks. Well, this might sound good on paper but it’s not practical in real life because PE ratios vary from industry to industry.
A company might be growing slowly today but still holds a lot of potential in the coming future. Therefore, solely using the P/E criterion might have you missing out on any such promising opportunities.
2. Create Your Watchlist
Once you feed these criteria to your stock screener, it will generate a list of companies that you need to watch. However, in some cases, the list generated might be too long and you'll need to narrow it down to the actual gems by considering the following key factors.
Long Term Profitability
A good stock to buy is one that comes from a company that makes consistent profits and maintains a good free cash flow.
In some cases, you’ll find companies with huge net profits but extremely poor free cash flows. Avoid those ones as they might be manipulating their data.
You are better off working with a company that keeps its debt figures as low as possible. Companies with high debt profiles tend to have their ROE inflated – effectively making them overvalued.
A company might be doing good today just because there isn’t much competition around. Add to the competition and the company starts to report dismal numbers.
In a nutshell, avoid companies that do not have a unique competitive edge or ones operating in industries with low barriers of entry.
Some key features to look out for (and ones that give a company a competitive edge) include trademarks and patents among others.
How Good Is the Management?
Before you settle on an undervalued stock to buy, it is important to carry out a background check of the management team behind it. A good company to invest in is one that has a clear ownership structure along with a team that is experienced, skilled, and ethical.
Avoid companies with shady ownership structures or team members with a checkered past.
3. Calculating the Intrinsic Value of a Stock
Having narrowed down to a small list of companies whose stocks are undervalued and yet of high potential, it’s time to calculate the actual (objective) value of the specific companies you’d like to put your money in.
The idea here is to find a stock whose price is at least 25% lower than its intrinsic value. Again, you want to avoid companies that are overvalued or whose price is slightly below the intrinsic value (so you have a good margin of error).
Wondering how to compute the intrinsic value of the stock you’re interested in? Here’s how to do it.
The Price/Earnings Ratio Method
This is now where it makes sense to use the P/E ratio. Simply do this by dividing the company's share price by earnings per share. A good way to eliminate bias is by computing a stock's P/E over the last 5 years.
That way, you’ll get a rough idea of how consistent the company’s P/E valuation has been over time. And it also alerts you about the potential a company has been building up over time.
A good way to get a company’s intrinsic value is by multiplying its earnings by the industry's average P/E ratio also.
The Discounted Cash Flow (DCF) Method
This is yet another method of arriving at a stock’s valuation in line with its projected future cash flows. With this approach, you use a discount rate to assess whether the stock is worth pursuing.
Generally, if the stock cannot generate enough cash flow to exceed the risk-free rate (i.e., treasury rate), it’s not worth pursuing.
The Return on Equity (ROE) Method
Equity is equal to assets minus liabilities. Therefore, ROE is a measure of the returns that can be generated against the real assets of a company. Therefore, this can give you a better look at what a company is really worth.
At this point, you’ll want to put your focus on companies whose ROE falls within the 15 to 20% range.
If you can’t find one within that range, make a point of analyzing the stocks relative to their sector performance. In that case, you’ll want to go for the best performing stock in that sector but one with at least 10% ROE.
The more a stock is undervalued, the better. This is the rule you should always keep in mind as an investor. Remember, the real gems are hidden somewhere in the market and no one is talking about them. The minute the media and noteworthy investors start talking about them it will be game over.
Luckily, the process of finding undervalued stocks is now much easier than ever as you can use stock screeners to scan the market based on your preferred criteria.
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