Undervalued stocks and how to find them
Investors look for undervalued stocks in order to make a higher return and reduce the risk of losing money on their investments.
What is an undervalued stock?
A stock is considered undervalued when its market price is below its intrinsic value. The intrinsic value of a stock is considered the real value of the company. Buying an undervalued stock can be compared like buying five-dollar bills with one-dollar bills.
How to find undervalued companies?
To find undervalued companies we are first going to look at the key metrics of the stock. These are commonly used ratios and percentages like P/E (price to earnings) and ROE (Return on equity).
However, before we start analyzing companies, we need to have a small basket of stocks to look at. An easy way to filter out companies you don’t want to see is by using a stock screener. A stock screener can be found here.
What key-ratios indicate cheap stocks?
Generally speaking, we would look at the following metrics to find valuable companies:
- Price to book value (P/BV < 1.5)
- Enterprise value to EBIT (EV/EBIT <10) Enterprise value to EBIT could generally be seen as a more accurate price to earnings ratio as it compares the price you would pay to buy the whole company (Market cap + debt – cash and cash equivalents) to its earnings before interest and taxes.
- Price to earnings ratio (P/E < 10)
- Current ratio > 1 The current ratio is calculated by dividing Current assets with current liabilities, This metric tells the investor whether the company will generate enough cash in the next 12 months to pay off its short – term liabilities.
- Return on Equity (ROE > 10%)
- Return on Assets (ROA > 5%)
- Return on invested capital (ROIC > 2%) A company with an ROIC higher than 2% is generating value, a company with an ROIC lower than 2% is destroying value.
The perfect stock doesn’t exist
So all you have to do is find a good stock screener, put in those ratios’ as shown above and … You have a list of stocks to buy!
Well.. not exactly.
There is simply no perfect stock that will comply with all the metrics we would like them to. Instead, you should consider those metrics as guidelines. Use some of these metrics to filter your list of companies to analyze.
Great rewards demand great analysis
We use a stock screener and ratios as a preselection. The only reason for doing that is to find a handful of companies that are worth investing our time to do a thorough analysis.
Before we decide whether or not to invest in a certain company, we need to look at its financial reports that contain important documents like the balance sheet, the income statement, and the cash flow statement.
Beware of value traps!
A mistake starting value investors often make is to put way too much emphasis on the numbers. When analyzing businesses you should also look beyond the numbers.
Who is the management? What is the MOAT of the company? How has the business been performing in the past? What is the competitive advantage of this company? Who are their competitors?
These are all important questions to ask because it will be a valuable indicator of whether or not this business will be able to perform at the same margins or even better than it has done in the past.
The importance of estimating future earnings will become clear when we calculate the intrinsic value of a stock.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” ~ Warren Buffett