If you could buy an undervalued stock for $50 that is actually worth $80, you’d do that deal without hesitation right?
Of course, you would.
Unfortunately, value investing is a bit more complicated than that, right?
Finding undervalued stocks to add to your portfolio is a great way to find amazing bargains that pay off in the long term. Think of identifying and investing in these stocks as getting great bargains on winning stocks.
Sounds too good to be true, we know, but what if you could learn how to identify undervalued stocks? That would open a lot of exciting opportunities in your portfolio wouldn’t it?
In this guide, we’re going to show you how to find undervalued stocks as well as teach you how to invest wisely for the future.
1. Why are Stocks Undervalued?
Before you can start choosing a stock to buy, you need to understand how and why that company is undervalued.
There are a ton of reasons why a stock could become undervalued, but they generally fall in one of three categories:
Bad news or bad quarterly reports
If a company misses quarterly earnings expectations, shares could plummet far more than they should. Additionally, if a company has a massive recall on their products, has an executive involved in a public scandal or suffers other forms of unfortunate press clippings, share prices could drop considerably in a short period of time.
Depending on the news or earnings reports, these could be the easiest forms of undervaluing to diagnose. Be sure to do your own homework though to understand just how serious the bad news is first.
Some sectors tend to be more volatile or at least more cyclical than others. For example: when the economy is going strong, companies that supply discretionary spending opportunities for consumers tend to do well like restaurants or car manufacturers. If you are trying to find undervalued stocks, find sectors that are out of favor for good bargains.
Market crashes and corrections
If there is a market pullback, it’s a great time to look for undervalued stocks. A word of warning, however, never try to time the market. No matter how good of an investor you may think you are, timing the market is almost impossible.
2. Know How to Evaluate a Stock
This seems pretty self-explanatory, but you have to do your homework in order to find the right undervalued stocks.
Remember, this is a topic they write entire books on, but we’ll give you some quick starting points. First, understand the traits of the companies you’re looking at:
- Profitability (“How much money is the company making?”)
- Growth (“How much more money should I expect the company to make in future?”)
- Liquidity (“How quickly does the company turn assets into cold, hard, cash?”)
- Solvency (“What’s the risk of this company hitting the rocks of bankruptcy?”)
- Valuation (“Am I paying a low, fair, or high price for the company, considering all the previous points?”)
Such traits can be appraised using a multitude of tools but be aware – not every tool is useful in every situation; avoid the old “To the man with a hammer every problem is a nail” cliché. Let’s cover some of tools that will start giving you understanding of the above traits.
Tools for Evaluating Undervalued Stocks
- Price-to-earnings (P/E) ratio: A “Valuation” tool – Divide a stock’s current share price by its annual earnings. A lower P/E implies a stock is potentially undervalued.
- Price-to-book (P/B) ratio: Another “Valuation tool – Divide stock price by the book value per share. All else equal, lower means cheaper, but be sure to appraise it in the context of the type of company you’re evaluating (i.e., it may be “cheap for a reason”). The P/B ratio can be quite useful for financial companies; it can be quite useless for, say, software companies.
- Debt-to-equity ratio: A “Solvency” tool – Acts as a way to gauge financial risk. A higher ratio means more leverage. Divide a company’s total debt by its shareholders’ equity.
- Return on equity (ROE): A “Profitability” tool – Calculated by dividing a company’s annualized net income as a percentage of shareholders’ equity. This can help an investor better understand how efficient a company is at generating profits from its equity financing.
- Current ratio: A “Liquidity” tool – A measure of a company’s ability to cover its short-term obligations. Calculate by dividing a company’s current assets by its current liabilities. Generally, higher is better.
These are just some of the many tools that can be brought to bear in order to evaluate the worthiness of a stock for your portfolio. There are other, somewhat “softer” factors, however, that you should also consider, including:
- Learning the history/story of the company
- Distill down the factors you think matter most for your particular company. For example, “Subscriber Growth” and “Average Revenue per Customer” would be important for a video streaming company like Netflix – but they’re irrelevant for a home improvement company like Home Depot. There, you probably care more about the speed with which the company turns inventory into sales/cash, and the rate of new store growth.
- Evaluate the value of the company over time. Valuation isn’t an ever-fixed mark. Consider that over the course of a year, a company’s price might have variance of 50% or more as the market flips between euphoria and despair in regard to its future performance. Sure is nice to be a buyer when the market hates a company as opposed to overpaying because of enthusiasm.
3. Do Comparison Shopping to Find Undervalued Stocks
Have you ever been driving on a road trip and have to stop for gas? You see two different stations with two different prices.
Naturally, being the money conscious person that you are, you go with the cheaper option.
One way value investors evaluate whether a stock is undervalued is to look at similar companies in the same industry and compare metrics. If all else is equal and Company A trades at a price-to-earnings multiple of 15 and Company B trades at 25, Company A might be undervalued.
As part of your research, you will want to find companies that are close to one-to-one comparisons as possible so you can get a clear idea why one company is priced different than another.
Considering the following points:
- Did one company get bad news or negative press compared to the other?
- Based on the metrics we discussed earlier, is the higher priced competitor overvalued in comparison?
- Are there new products or services that puts one of these companies in a more advantageous position?
- How do the pricing trends over time compare between the two companies?
4. Focus on Industries You Know (and Master Them)
At The Motley Fool, we believe diversification is important. We also believe, however, that you should play to your strengths and master an area of investing before trying to take on too much.
When searching for undervalued companies, focusing on a couple of industries you are familiar with and understand will set you up for long-term success. Much like working out or learning to ride a bike – practice and training makes perfect.
If you focus on a couple of industries, you should be able to identify undervalued companies more easily in those sectors. For example, different industries have different average P/E ratios, so what may work well in say software companies may not work well in the energy sector.
5. Have a Long-Term Mindset
Do you want to make a lot of money as quickly as possible?
Who doesn’t, right?
The reality, however, is that life altering investing takes time. Like, decades. Finding undervalued stocks is one thing. For the market to realize that they’re undervalued is another.
More frustratingly, the market can quickly change making your once watched undervalued pick more expensive and less attractive while you do your research. That’s part of the fun of being a value investor: waiting to find the bargain you are looking for and not feeling the pressure of making a deal just to make a deal.
The worst thing you can do is talk yourself into an investment you are later going to regret just to “do something.”
If you follow the principles we’ve laid out, your opportunity is going to come, and when it does, you are going to happier (and wealthier!) for it.