Every investor can think of a stock they’d been watching that soared in value after reporting a stellar earnings report. Or a company that had their market cap triple (or more) as the market realized the firms true worth and superior business model.
But finding these stocks before they pop can be extremely difficult…
The terms undervalued and overvalued stocks are used almost daily in the world of finance, and more importantly, is a strong justification as to why a specific company or stock is considered a buy or sell by many professional investors.
Today were going to be covering everything an investor would need to know to successfully identify and buy undervalued stocks before the rest of the market clues in.
We’ll define what exactly an undervalued stock is, why investors should focus on undervalued companies, give a step-by-step process to identify undervalued stocks, cover some of the most famous (and successful) value investors in history, and finally, we’ll talk about the most important thing every investor should keep in mind when looking for undervalued stocks.
What Are Undervalued Stocks?
Undervalued stocks are companies whose share price is currently trading at a lower price than their intrinsic (or fair) value.
Investors will use metrics like revenue growth, assets owned, debt, and cash flow generation, among many others in an attempt to determine what a company is worth today. Doing so, presents the opportunity to invest in companies whose current market cap is well below what the company is actually worth.
A stock may be considered undervalued for several reasons, including a temporary setback in the company’s performance, negative market sentiment towards the industry or sector, or simply a lack of investor awareness.
The principle of looking for value is something all investors can relate to. In the same way, consumers look for value in the clothes they buy or the car they drive, investors look for value in the companies they invest in. By identifying stocks that trade below their fair value allows investors to profit when a stock inevitably moves higher to reflect its true worth.
Why Invest in Undervalued Stocks?
The justification for investing in undervalued stocks is simple – investors want to make money – and successfully identifying undervalued stocks is a surefire way to achieve lasting financial success.
More specifically, undervalued stocks have the potential for significant upside. When a stock is undervalued, it means the current market price is lower than its intrinsic value, indicating that today’s price is a discount to where it will trade in the future. As market conditions improve and the company’s performance gains the attention of others, the stock has the potential to rise in value, offering significant gains for investors.
Secondly, investing in undervalued stocks can provide a margin of safety for investors. When a stock is undervalued, it offers a lower downside risk than a stock trading at a premium valuation. Even if the company’s performance does not improve, the stock is already trading at a discount, limiting potential losses for investors.
Finally, investing in undervalued stocks can provide diversification benefits. By investing in undervalued firms, investors can diversify their portfolio by adding exposure to stocks that may be overlooked by the broader market. This can help to reduce overall portfolio risk and potentially increase returns.
Simple Guide to Finding Undervalued Stocks
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If you’re struggling to determine where to start when looking for undervalued companies, here’s a step-by-step guide to get you started. This is by no means an exhaustive list, however it can be a great framework to use when first starting out.
As you become more comfortable in your research and due diligence process, feel free to add, adjust, or skip steps as needed.
Make Sure You Understand Basic Financial Metrics
Before you start searching for undervalued stocks, it’s important to understand basic financial metrics such as market cap, earnings per share (EPS), price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and return on equity (ROE).
These metrics can help you evaluate a company’s financial health and determine whether its stock is undervalued or overvalued. (If you don’t know these financial metrics, don’t worry; we’ll cover them in more detail below).
Pick Your Industry
Once you understand basic financial metrics, you can start narrowing down your search by picking an industry you want to invest in. When analyzing stocks and comparing financial metrics, it’s important to understand industry averages, as well as only to compare companies that are in the same industry.
Different industries are valued differently, and a common mistake investors make is comparing two organizations who have entirely different business models, profit margins, revenue expectations, and more. Make sure to compare a company to their industry peers and broad industry averages to get an accurate picture of how under or overvalued a company is.
Use Stock Screeners
Stock screeners are powerful tools that help you narrow your search for undervalued stocks.
Screeners allow you to filter stocks based on specific criteria such as P/E ratio, P/B ratio, dividend yield, and market capitalization.
Using a stock screener can help you quickly identify undervalued stocks that meet your specific investment criteria.
Analyze and Compare Valuation Metrics
After using a stock screener to identify potential undervalued firms, analyzing and comparing valuation metrics is important to determine which stocks are truly undervalued. Below are the most applicable and important metrics investors should be using during the research phase:
- Price-to-Book Value (P/B): A price-to-book metric shows a company’s share price compared to their book value (or assets currently on their balance sheet). A company with a lower P/B ratio than its peers may indicate that the stock is undervalued.
- Price-to-Free Cash Flow (P/FCF): Another valuation metric that investors can use is the P/FCF ratio, which compares a company’s market capitalization to its free cash flow. By considering how much cash a company is generating relative to its market value, investors can assess the financial health and ability for a company to use their cash to generate further revenue growth.
- Price-to-Earnings Ratio (P/E): The P/E ratio is the most commonly used valuation metric that compares a company’s stock price to earnings per share (EPS). A lower P/E ratio shows a company value is in line (or sometimes below) their current earnings, which can be a strong indicator a firm is currently trading below their fair value.
- Price-to-Sales Ratio (P/S): A fourth metric to consider when evaluating undervalued stocks is the P/S ratio, which compares a company’s market capitalization to its top-line revenue. This is a common metric used to evaluate firms who aren’t yet turning a profit.
- Return on Equity (ROE): To determine how efficiently a company is using its equity to generate profits, investors can use the ROE metric. By dividing a company’s net income by its shareholder equity, investors can gain insight into how efficiently a company generates a profit.
- Dividend Yield: For investors seeking steady income, the dividend yield can be a useful metric to consider. By measuring the amount of dividends a company pays as a percentage of its stock price, investors can assess whether a stock is a good long-term income producing asset.
- Current Ratio: To determine a company’s ability to pay off its short-term debts with its current assets, investors can use the current ratio metric. A higher current ratio may indicate that a company is financially stable and has a lower risk of defaulting on its debts, whereas a lower current ratio is a sign a company will be unable to pay incoming debt payments.
- Price-Earnings to Growth (PEG) Ratio: Finally, the PEG ratio compares a company’s P/E ratio to the company’s earnings growth rate. This metric can provide insight into whether a stock is undervalued relative to its growth potential, and can be a useful tool for growth investors who constantly have to deal with companies whose share price is usually seen as overvalued based off more traditional value-based metrics.
The most effective way to use the metrics and ratios listed above is to use a combination of them and compare a company against industry and historical averages, as well as that of their industry peers. Different metrics tell different stories and investors should take their time and compare multiple metrics when determining the true value of a stock.
Research Company Projects & New Initiatives
In addition to analyzing valuation metrics, it’s important to research a company’s projects and new initiatives. This can help you determine whether the company has the potential for future growth and whether it is undervalued due to a temporary setback or a lack of investor awareness.
For example, if a company has recently announced a new product launch or expansion into a new market, it may have the potential for future growth that is not yet reflected in its current market price.
Determine Investing Strategy
After identifying undervalued stocks, it’s important to determine your investing strategy. This can include deciding whether to buy and hold the stock for the long term or to trade the stock for short-term gains.
It’s important to have a clear investing strategy before making any trades to avoid making emotional decisions based on short-term market fluctuations.
Make Your Trade
Once you have identified an undervalued stock and are comfortable with your investing strategy, you can finally make your trade.
Make sure to keep track of the stock’s performance and to periodically re-evaluate your investing strategy, as well as the company’s current market value to ensure that it still aligns with your investment goals and the stock hasn’t gone from being undervalued to overvalued.
Famous Value Investors
It’s one thing to hear about the metrics and theory behind how to find undervalued stocks, but what’s really valuable is to understand what it looks like in practice.
To show the success of finding undervalued stocks we’ve identified four famous value investors who rely on the same metrics and process we’ve highlighted today to help them achieve investing success. We’ve also included one lasting quote from each, that sums up how they approach investing in public financial markets.
Image Source: Forbes
Warren Buffett is widely regarded as one of the most successful value investors of all time. He is the CEO and Chairman of Berkshire Hathaway and has built his fortune through identifying undervalued companies with strong fundamentals and holding them for the long-term.
Buffett famously said: “Be fearful when others are greedy and greedy when others are fearful.” This reflects his contrarian approach to investing, where he seeks to buy undervalued stocks that others are overlooking or selling. He also famously avoids investing in companies he doesn’t understand or whose business models he doesn’t believe in.
Buffett’s success in finding undervalued stocks can be seen through his investments in companies such as Coca-Cola, American Express, and Wells Fargo. These were all companies he identified as undervalued and held onto for many years, allowing their value to be appreciated over time as other investors realized their economic importance, superior product, and impressive financials.
Image Source: CNBC
Bill Ackman is a hedge fund manager and founder of Pershing Square Capital Management. Ackman’s investing strategy involves identifying undervalued companies with strong growth potential and taking large positions in smaller companies. He is also known for his activism in pushing for changes in the companies he invests in, such as advocating for board seats or suggesting changes in company strategy.
Ackman’s most famous quote is “If you find a company with a strong long-term growth plan, buy it and hold it forever.” This reflects his focus on finding undervalued companies with strong fundamentals and holding them through periods of volatility. He also believes in minimizing his diversification in order to focus his portfolio on his highest-conviction stocks.
Image Source: Fidelity Investments
Peter Lynch is a former fund manager and author of the book “One Up on Wall Street.” Lynch’s investing strategy involved identifying undervalued small caps that had not yet gotten the attention of other hedge funds or the rest of Wall Street.
Lynch’s most famous quote is “Invest in what you know”, reflecting his focus on investing in companies that he understands and interacts with daily.
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Charlie Munger is a businessman and investor, and is the Vice Chairman of Berkshire Hathaway (alongside Warren Buffet). Munger’s investing strategy involves identifying undervalued companies with strong fundamentals and a lasting competitive advantage or moat, such as strong brand recognition or unique technology.
Munger is most famous for saying “We try more to profit from always remembering the obvious than from grasping the esoteric.”, meaning the simplest way to achieve investing success is to remain grounded in your underlying strategy, and capitalizing on the mistakes and emotional decisions of other investors.
Most Important Thing When Analyzing Undervalued Stocks
When analyzing undervalued stocks, it is essential to remember that a company’s value is subjective, and what may seem cheap or expensive may not necessarily align with the market’s sentiment. This can make identifying undervalued stocks challenging and increase the potential for value traps.
Value traps occur when a stock appears to be undervalued but fails to appreciate in value over time. This is often due to underlying issues within the company, such as declining revenue, high debt, or other negative trends.
One famous example of a value trap is Sears Holdings. In the early 2000s, Sears was trading at a discount to its book value, which many investors saw as an opportunity to invest in a seemingly undervalued stock. However, Sears’ declining sales and lack of a competitive edge resulted in the company’s eventual bankruptcy, causing significant losses for investors.
This is an excellent illustration of how subjective a company’s intrinsic value can be.
Further, traditional valuation metrics may not always be the best way to evaluate a company’s worth, and it’s essential to consider other factors, such as future growth potential, management quality, and competitive advantages, when researching potential investment opportunities.
It’s also essential to remember that different investors may (and most likely will) have varying opinions on a company’s value. In other words, a company that appears undervalued to one investor may not seem undervalued to another. As a result, it’s critical to be objective and remain open to varying opinions when looking for undervalued stocks.
In short, finding undervalued stocks can be a challenging but rewarding task for investors.
By conducting thorough research and analysis, investors can identify companies that are trading at prices below their intrinsic value, providing an opportunity to make a profit as the market eventually recognizes their true worth.
Some of the key methods for identifying undervalued stocks include analyzing financial statements, picking specific industries to research, examining company initiatives, and looking for companies with solid fundamentals.
It is important to note that no investment strategy is foolproof and there is always some risk involved, but with careful consideration and a long-term perspective, investors can build a solid portfolio and lasting financial success through focusing on identifying undervalued stocks.