Investing

How to Find Undervalued Stocks

Looking for undervalued stock can be a bit like panning for gold. We’ll explain why.

Editor's Note

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Throughout the long history of the stock market, finding undervalued stocks has been one of the time-honored ways to outperform the market over the long term. It’s an approach involving buying stock in solid companies that are lower priced compared to their major competitors. When the market eventually discovers the company’s undervalued, the returns can be spectacular.

Think of it as an intentional strategy to buy low and sell high. You can buy low because most other investors are ignoring the undervalued company. But you can sell high if the market finally realizes the value of the stock and the price increases as new investors stampede in.

But how do you find undervalued stocks, particularly in today’s investment environment where computer investing and trading reflects valuation discrepancies almost immediately?

It’s all about looking at the fundamentals.

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Start with a Good Stock Screener

While it’s possible to rely on lists of undervalued stocks published either in the financial media or in investment newsletters, that might also remove the element of surprise that’s so important in successful investing. Put another way, just as you will learn about an undervalued company from a published source, so will thousands of other investors. Once that information becomes public, and there’s a recommendation behind it, the price may rise in a hurry and the stock will no longer be undervalued.

For that reason, there’s a strong panning for gold element for finding undervalued stocks. It takes a keen eye and plenty of elbow grease. And a good stock screener never hurts. That’s a tool you can use to research the metrics to determine if a stock is undervalued. It should also allow you to maintain a watchlist of potential stocks. After all, your own personally developed list of undervalued stocks can change on a continuous basis. While you’re adding some stocks to the watchlist, others may fall off as the metrics go against you.

Fortunately, there are several good stock screeners you can choose from.

One prominent example is Morningstar because it’s one of the most respected and quoted stock information and analysis sources in the industry. They offer two different stock screener versions. One is Morningstar Basic, which is free. And since it’s free, it offers more limited service, including fewer screening tools and portfolio management capabilities.

If you’re serious about finding good value stocks on a consistent basis, Morningstar Premium may be the better choice. It provides analysis and ratings of stocks, bonds, and funds, though it does have a heavy emphasis on mutual funds. But it also provides analyst reports, investment picks, and the Morningstar Portfolio Manager and Portfolio X-Ray. The premium version is currently available for a fee of $199 per year.

Another popular free stock screener is Yahoo Finance. Though it’s not as comprehensive as premium stock screeners, it is one of the most popular, and you can use it at any time without needing to provide personal information. It’ll work best if you only occasionally hunt for undervalued stocks.

Finbox is another premium stock screener that may be worth checking out. The company bills itself as the Most Complete Toolbox for Investors. And while that’s possibly a slight exaggeration, it is one of the most comprehensive stock screeners available. You can take advantage of over 800 financial metrics, and it also provides watch lists, charts, hedge fund portfolio trackers, and preset screens. It’s also worth noting they’ve partnered with S&P Market Intelligence for fundamentals and forecast data.

Finbox does offer a free version, but you’ll be most interested in a premium plan. One premium plan is available for $15 per month and includes the ability to import 250,000 spreadsheet data points. The other has a fee of $58 per month and provides both premium metrics and premium screen filters. It also comes with unlimited website exports as well as the ability to import 1 million spreadsheet data points.

Whichever stock screener you choose to work with, having one will go a long way toward helping you identify undervalued stocks on a consistent basis.

How to Find Undervalued Stocks

There’s no guesswork involved in the process of finding undervalued stocks. It’s a matter of evaluating the metrics of a given company, comparing it with the metrics of its major competitors, and making a determination if the price is in line with the competition, or if it’s truly an undervalued stock.

It’s important to understand that no single metric establishes a company as undervalued. You’ll be looking for a pattern of several metrics all pointing in the same direction. That will be the best evidence that the stock is undervalued.

Here are some of the prime metrics to help you make that determination:

Price/Earnings Ratio (P/E)

P/E ratio is the typical starting point to evaluate any stock you’re considering buying. P/E ratio measures the market price of a stock compared to company profits, or earnings. For example, if a company has earnings of $2 per share, and its stock is trading at $50, its P/E ratio is 25 $50 divided by $2.

So let’s say you find a company in a particular industry that has a P/E ratio of 15, but its major competitors are at 25. This can be a basic indicator that the company stock may be undervalued.

You cant look strictly at the ratio itself but must take a close look at the reasons why. For example, if the ratio is lower than the competition because of tangible reasons like declining earnings the company is not undervalued. In fact, it’s probably trading at its true value.

But if there are no major issues contributing to the low P/E ratio, you may want to include the company on your watch list of potentially undervalued stocks.

High Dividend Yield

The dividend yield is the dollar amount of the annual dividend divided by the share price of a stock. If the dividend yield on a stock is $3, and the stock is trading at $100 per share, the dividend yield is 3%.

If the average dividend for companies engaged in the same industry is 4%, the company’s 3% dividend yield is low for the industry group. But if the average for the industry is 2%, the company is displaying a high dividend yield.

Now to be fair, a high dividend yield can go in either direction. The yield may be high because the company’s fortunes have turned down. Investors may be shunning the stock out of fear of a decline in future earnings.

But on the other hand, if the high dividend yield has been consistent for several years, and the company has a solid track record of growing its earnings, the high dividend yield can be an indication of an undervalued stock. This can be especially true if the company also has a low P/E ratio in comparison with its major competitors.

Low Market-to-Book Ratio

This is the total market capitalization of the company’s stock divided by its shareholder equity. If this number is low, it can indicate the stock price is low relative to the net worth of the company.

This is a ratio that requires considerable caution. While the book value of a company may have been an important indicator of value in the past, it’s less so in the future. This is particularly true since so many companies today are engaged in service businesses or intellectual property, both of which involve relatively low asset bases. As well, analysts and investors tend to be more concerned with revenue and profit growth than with the company’s book value.

But a good indicator of an undervalued stock is a company with a low market-to-book ratio indicating the value of the company’s assets are high in relation to the market value of its stock. In rare cases, the net value of the company’s assets may be greater than the market value of the stock.

That usually indicates a company in distress, but it can be an undervalued stock situation nonetheless. A competitor may be willing to buy out the company for more than the current price of the stock simply to acquire the company’s assets. If you buy the stock prior to the acquisition by a competitor, you may get a quick profit on the stock when the acquisition takes place.

Low Price-to-Earnings Growth Ratio (PEG)

This ratio is a bit more complicated than the others. It’s calculated by dividing the P/E ratio by the company’s earnings growth rate. For example, if the company has a P/E ratio of 15, and a projected growth rate of 20%, the PEG will be 0.75%, which is 15 divided by 20.

In general, if the PEG is less than 1 which it is in the above example the stock may be undervalued. That’s because investors may be either unaware of the company’s high growth rate, or they’re ignoring it for whatever reason. Either way, a high-earnings growth rate is a solid indication of strong future price performance in the stock.

Other Metrics to Consider

While the ratios above can allow you to compare one company with another, there are even more general metrics to take into consideration.

One is the company’s revenue growth, particularly over the past two or three years. If the company’s major competitors are averaging 15% in annual revenue growth, but the company you’re considering is averaging 20%, it’s growing faster than the industry average.

Equally important is earnings growth because that indicates the company is increasing its profits commensurate with rising revenue.

Once again, if a company you’re investigating is seeing annual earnings growth of 15% over the past two or three years, and the industry average is 10%, the company’s profits are growing faster than its competitors.

Though there’s no guarantee, the likelihood is at some point the general investment community will come to recognize the faster growth the company is enjoying. Once they do, the stock price is likely to increase faster than the average for the industry.

Investing Through a Value Fund

If you decide you want to invest in undervalued stocks, but you don’t want to do all the research that’s involved, you can choose to invest through a fund that specializes in undervalued stocks.

One of the most popular is the Fidelity Contrafund (FCNTX). One of the largest funds in existence, it has nearly $140 billion in assets under management. There is no minimum investment required, though the expense ratio is admittedly high at 0.85%.

However, the annual returns on the Fidelity Contrafund have been impressive over the past decade. The fund has returned an incredible 39.81% in the past year, 20.79% per year over the past three years, 18.43% per year over the past five years, and the 10-year average annual return is 17.22%.

Windsor II Fund Inv (VWNFX) is a value fund with a focus on large-capitalization stocks. It has a lower expense ratio at 0.34%, but it does require a minimum investment of $3,000. The fund has returned 12.93% in the past year, an annual average of 8.88% over the past three years, 9.67% in the past five years, and 12.17% per year over the past 10 years.

If you do choose to invest in undervalued stocks using funds, you’ll need to be very selective in which one you choose. As a general rule, the group has underperformed on the S&P 500 over the past decade, so you may have difficulty finding a fund that will provide the returns you’re hoping to get.

Ready to get started? These are some of the best brokers to use for research.

Stockbrokers to Use

Ally Invest

Ally Invest is the online bank’s brokerage platform that offers both self-directed and managed investing services.

Keeping with Ally’s low-cost ethos, Robo portfolios have a minimum investment of just $100 and no advisory fees. People who choose their own investments can place stock and ETF trades with no commission, making it easy to buy and sell securities as you adjust your portfolio.

TD Ameritrade

TD Ameritrade is a well-known online brokerage company that also offers commission-free trading. One perk of TD Ameritrade is that it offers built-in investment research tools, making it easy to research stocks and place trades with a single interface.

E*TRADE

E*TRADE is another low-cost online brokerage that offers commission-free trading of stocks, ETFs, and options. The company provides a full suite of account types, including taxable brokerages and retirement accounts, as well as the opportunity to trade in mutual funds, futures, and other types of securities.

Learn More: The Best Tools to Research Stocks

Final Thoughts

It would be comforting to say that undervalued stocks will ultimately outperform the general market. But that’s not always the case. While it is true that new companies are added to analysts’ buy lists all the time, there’s no guarantee that a stock you are invested in or considering buying will ever appear on one of those lists.

Especially in recent years, the market has tended to favor certain large and popular stocks, like the so-called FAANG stocks (Facebook, Apple, Amazon, Netflix in Google). As well, the S&P 500 which represents stocks of the 500 largest publicly traded corporations has been outperforming most other sectors for at least the past decade.

When it comes to investing, you can generally expect current trends to continue, at least until there is a major change in market dynamics that shakes up the order.

But should that happen particularly in the case of a prolonged bear market undervalued stocks may suddenly get a lot more attention from analysts, portfolio managers, and individual investors. It’s a sector worth following, even if you don’t plan to invest in it immediately.

Want to know more? You can find the stock screeners we mentioned in this article in the links below:


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