Looking for undervalued stocks can feel like looking for a needle in a haystack. Finding the next Amazon or Facebook is not an easy feat, especially when there are thousands of stocks to choose from in the stock market. However, the beauty of finding undervalued stocks is the potential to find companies on the verge of going to the moon or skyrocketing. No matter how much time passes, I will never get over my excitement of seeing double or triple-digit positive returns on my investments. If the returns occur in a short amount of time, then even better!
If you’re looking for some deeply discounted stocks, we’re here to teach you how to do just that with our comprehensive guide on value investing.
- The goal of value investing is to find undervalued stocks and profit when they rise to their fair value.
- Top indicators used to find undervalued stocks include the price to earnings (P/E) ratio, earnings per share (EPS), price to book ratio, debt to equity ratio, dividend yield, EV/EBITDA ratio, and cash flow.
- Five ways to identify undervalued stocks are (1) using stock screeners, (2) finding oversold stocks, (3) finding underappreciated stocks, (4) looking for the best stocks in undervalued sectors, and (5) buying stocks during a market correction.
What is Value Investing?
Value investing is an investment strategy where investors seek stocks that are trading significantly below their fair price value to profit when they return to fair value. The idea behind value investing is to buy shares for cheaper than what they are truly worth and wait for other investors to come to the same conclusion as you. It’s the epitome of the buy low, sell high strategy. By building a portfolio of undervalued stocks, an investor can get superior returns if everything goes as planned.
What are Undervalued Stocks?
A company that is trading significantly below its fair price is considered an undervalued stock. There is no clearly defined definition of what factors make a stock undervalued. But, the main idea is that the stock market is not valuing a company at its fair value. In other words, any company could be considered a value stock and can move in or out of its status as an undervalued stock.
The simplest way to find an undervalued stock is to look up the current market price and compare it to its fair value. For example, let’s say that you’ve done your research and believe that the fair value of Netflix is $600. However, Netflix is currently trading at $530. Based on your calculations, Netflix would be about 12% undervalued, potentially a good buying opportunity. If Netflix is trading at $650 instead, you would say it’s about 8% overvalued and wait until it falls to the fair value before buying.
Value Stocks vs. Growth Stocks
When investors talk about value investing, they often contrast it against growth investing. In this context, growth stocks are companies such as Google, Amazon, and Netflix, which scale and innovate quickly, whereas value stocks are slow-growth companies, such as JP Morgan Chase & Co and Walmart.
However, note that slow growth doesn’t always mean that a stock is undervalued. When we talk about value stocks, there are two different definitions. One is referencing companies that are trading below their fair value. The second is slow-growth companies or the opposite of growth stocks.
If we compare value stocks directly with growth stocks, the key difference is the timeframe used. Value investing focuses on the past, while growth investing focuses on the future. With value stocks, investors are more interested in stability and predictability. With growth stocks, investors have strong expectations about their future revenue potential, thus pushing share prices up to unprecedented highs.
For a company to get priced below its fair value, there has to be something wrong with its current market price. As a value investor, you look for information that contradicts the stock market’s assessment to take advantage of the discrepancy between a stock’s market value versus its fair value.
How Do Stocks Become Undervalued?
Before diving into the specifics on ways to find undervalued stocks, let’s cover some of the reasons why companies become undervalued. With the rapid dissemination of public information on the Internet, shares of stocks can become oversold under many scenarios.
If a company reports earnings that do not meet investor expectations, its stock could sell off quickly during after hours. If an influential figure, such as Elon Musk, tweets something that gives off negative sentiment towards a company, it could sell off excessively. If multiple analysts downgrade a stock or negative news coverage resulting from a short-term issue comes up, it could sell off. Other common scenarios include government regulation, lack of investor interest, poor company management, supply chain bottlenecks, overleveraged debt, legal issues, and market crashes.
As a value investor, if any of the situations above occur, you should raise your eyebrows and question whether the scenario warrants a selloff. If the issue is not as terrible as other investors made it out to be, then you may have found an undervalued stock worth investing in.
Finding Undervalued Stocks – Top Indicators
Price to Earnings (P/E) Ratio
The price-to-earnings ratio is one of the most commonly used measures of a stock’s value. It gets calculated by dividing the stock price by earnings per share. The higher the P/E ratio, the higher the stock price relative to the company’s profits. Companies with high P/E ratios are either overvalued or have high expected growth potential. Most growth stocks will fall under this category as investors are willing to pay for their future revenues and earnings prospects.
To find undervalued companies, look for stocks with low P/E ratios relative to their industry peers. If you compare companies in vastly different industries, you could be comparing apples to oranges. Some sectors, such as technology and EV, tend to be more focused on the future. So, companies in these sectors will have higher P/E ratios than consumer staples or banks.
A company with a low P/E ratio could be a good buying opportunity if you believe its future earnings growth is higher than what the measure indicates. However, sometimes companies have low P/E ratios for a reason, so try not to rely solely on this metric to make decisions. There are countless examples of companies fudging their financials or lying about their product or service offerings (Hint: Nikola). As an investor, make sure to stay informed and use the P/E ratio as a starting point rather than a single source of truth.
Earnings Per Share (EPS)
Earnings per share is an important metric used to estimate a company’s value and profitability. It gets used to calculate the E in P/E ratio. A company’s EPS gets calculated by dividing its profit by the number of outstanding common shares. In other words, EPS tracks how much a company earns for each share of its stock. Companies with high EPS are generally more valuable because investors are willing to pay more for shares of their stocks.
EPS gets commonly used to track a company’s performance. However, most shareholders will not have direct access to company earnings. So, the EPS is compared to the market share price of stock instead to get a sense of future growth potential.
Price to Book (P/B) Ratio
The price to book ratio compares the current price of a stock to its book value per share. A company’s book value represents its worth after selling off all its assets and repaying liabilities. You can find this metric on a company’s balance sheets or website. To calculate a company’s book value, subtract its liabilities from its assets. Companies often trade at higher valuations than their book value because investors expect them to keep operating and growing.
The opportunity here is to look for companies with a P/B ratio of 1 or less because this is an indicator that they may be undervalued. The stock market is not always right about company valuations. If you discover a company with a low P/B ratio, but growing faster than expected, you may have a buying opportunity. If you make a correct prediction, you’ll see high returns. However, note that not all stocks with low P/B ratios are valuable. Companies with low price-to-book values are more likely to be at risk of going out of business and could have slow expected growth.
Debt to Equity Ratio
The debt to equity ratio is a handy measure to eliminate highly leveraged stocks as companies with high debt levels may be facing financial troubles. It gets calculated by dividing a company’s total debt by its total equity. Companies with high D/E ratios are more likely to be negatively impacted by economic changes and pay higher costs for capital.
We recommend looking for companies with debt to equity ratios of 1 or less. Companies with D/E ratios less than 1 have more assets than debt, which is a signal of stability and economic strength. You can either calculate this metric yourself or look it up on a company’s website.
A dividend is a payment that companies distribute to shareholders to share their earnings with investors. The dividend yield is the dividends per share divided by price per share. Companies that are more stable and mature usually distribute dividends to shareholders on a quarterly or annual basis. To see if a company pays dividends, check its stock profile and confirm that it has a dividend yield posted.
One way to find undervalued stocks is to seek stocks that pay consistent or increasing dividends each passing year. If a company’s dividend payment rate is much greater than its competitors’ rates, that could be a sign that its share price is undervalued. Getting passive income through dividends is a great way to wait for undervalued stocks to rise to their fair value while making a small profit on the side. Make sure to dig into the company’s financials and future dividend payments. That way, you ensure that your dividend returns are secure and that the stock price has a high possibility of rising in the future.
A screening method that has risen in popularity recently is the Enterprise Value (EV) to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) ratio. The EV portion of the formula calculates a company’s total worth, while EBITDA assesses a company’s financial performance and profitability. It is a popular valuation tool that compares a company’s value to its cash earnings minus non-cash expenses. Many investors today use the EV/EBITDA ratio to compare companies within the same industry or sector.
To calculate a company’s EV/EBITDA Ratio, you can use this formula:
EV/EBITDA = (Market value of equity + Debt – Cash) / EBITDA
Look for companies with an EV/EBITDA value below ten because that is an indicator of their health. The lower the EV/EBITDA ratio, the cheaper a company’s valuation is. However, a few downsides of this metric is that it removes taxes from the equation and could cover up lower returns because depreciation and amortization are added back to earnings.
For some investors, cash is king. Cash flow lets you know how much money a company is holding in its reserves. Companies with steady or increasing cash flow indicate that their stocks are more liquid and easier to access. We recommend avoiding companies with negative or decreasing cash flow. Search for companies with positive cash flows but low prices, as they are most likely undervalued. To find a company’s current cash flow, check their balance sheets or stock profile.
Free Cash Flow
Rather than focusing on reported profits, many investors focus on free cash flow instead, or the amount of cash a company generates after accounting for all expenses. Free cash flow is an important metric that tells you how much cash a company has in its reserves after covering all its expenses.
Operating Cash Flow
A company’s operating cash flow tells you how much cash gets used for operations. Investors often use this metric to determine how financially successful a company’s core business activities are. There are two ways to show a company’s operating cash flow on its financial statement: the indirect and direct methods. Under the indirect method, a company’s net income is adjusted using changes in non-cash items, such as accounts receivable and payable, and depreciation, to reach a cash basis figure. Under the direct method, a company will record all its transactions on a cash basis and use actual cash inflows and outflows on its cash flow statement.
Financing Cash Flow
A company’s financing cash flow gives you insight into its financial strength and capital structure management. It tells you how much the company is making in the financial markets, plus how much it is losing or making through a loan or debt servicing. If the financing cash flow is high, this could indicate that financiers see the company as high risk.
How to Find Undervalued Stocks
1. Use a Stock Screener
If you want to automate your screening process, consider using a stock screener. There are many free and paid online tools available to investors that give you the ability to screen investment ideas in seconds. Tools such as Google Stock Screener, Yahoo Stock Screener, MOMO Stock Scanner, and Ally Invest’s Stock Screener, for example, allow you to set criteria for finding undervalued stocks.
Some examples of things to screen for include:
- Market cap – focusing on large-cap or mid-cap companies only
- Sector or industry – looking for the stocks with the most potential in each sector
- Dividend yields – seeking stocks that pay out regular dividends
You could set many of the metrics mentioned above in your criteria as well, such as P/E ratio, P/B ratio, EV/EBITDA ratio, and more. Once you decide on your idea criteria, the screener will only show you stocks that fit your criteria. If you’re on a time crunch, using a stock screener is a great way to zone in on undervalued stocks in seconds.
2. Find Oversold Stocks
A simple way to find undervalued companies is to look for stocks that have sold off dramatically, particularly after a disappointing earnings call or quarter. While it’s hard to predict what investors will do, you can generally assume that a company’s stocks will tumble if it does not meet investor expectations. To find out this information, you can read financial sites, watch the news, or look up upcoming earnings calls. For example, Webull has calendars for upcoming earning calls, dividends, and splits under its “Explore” section.
While looking for oversold stocks, make sure the companies you’re looking at have stable histories and maintain a good S&P rating. These types of data are indicators that they are still good buys. Other technical indicators you can use are candlestick patterns, moving average crossovers, and support and resistance. Remember, bad news for the companies could be good news for you!
3. Find Underappreciated Stocks
Finding underappreciated stocks is a strategy heavily used by Warren Buffett, the Oracle of Omaha. This strategy entails seeking unpopular stocks with significant unappreciated value. According to Buffett, we can think of the stock market as a popularity contest that reflects everyone’s opinions, from investors to speculators to traders. However, their opinions are not always grounded in reality, thus can drive prices up for no good reason. Instead of following everyone else like sheep, seek out companies that are not sexy or trendy, but are still profitable.
4. Look for the Best Stocks in Undervalued Sectors
Sometimes investors tend to avoid entire sectors or industries because they see them as unprofitable or less valuable. Because of my tech background, I invest primarily in technology and innovation stocks. Most of the time, I ignore consumer staples and consumer discretionaries. In hindsight, I have often been too focused on growth stocks and not given credit to other sectors that have performed well in the past year.
One way to build a solid portfolio is to identify undervalued sectors or industries and seek out champions within each individual sector. Different industries measure success differently, so start by understanding expectations for one or two. For example, as I was looking for stocks to buy, I noticed that the healthcare sector was undervalued. I started looking for rising stars in that sector and adding them to my watchlist. I also looked into ETFs that encompassed different undervalued sectors. That way, I could invest in the entire industry instead of trying to handpick individual stocks.
5. Buy Stocks During Market Corrections
During a market correction, you can be sure that most stocks will be a bargain. When the market crashes, most investors panic and sell their stocks to minimize losses. However, as Warren Buffett says, “Be fearful when others are greedy, and greedy when others are fearful.” If we take a look at a graphical animation of Buffett’s portfolio at Berkshire Hathaway from 1994 to 2021, we can see that there are several years where he outperforms the S&P 500.
Limitations of Value Stocks
If everything goes as planned, value investing is a great way to get positive returns. However, there is a risk that the stocks keep sinking. A commonly used phrase investors say is “trying to catch a falling knife.” This phrase refers to the idea that you will bleed money profusely if you invest in stocks that keep hitting lower lows.
Undervalued stocks usually have low share prices and limited growth potential, especially when compared to growth stocks. That means if you invest in value stocks, you may have fewer profits from capital gains than if you invest in growth stocks. With value investments, you also risk the possibility of investing in struggling or failing companies. Sometimes, stocks are trading at low prices for good reasons.
Value investing is a long game. You could be waiting for months or years before the stock market values companies at the fair prices you calculated. Because you are waiting for the market to correct itself, that opens up the possibility of “value traps” or stocks that never realize their fair value for whatever reasons.
One of the main reasons why some companies are priced so low is because they are susceptible to disruptive technologies or fierce competitors. If we look at Netflix, we can see that it is a disruptive force that forever changed the way we consume media. Blockbuster failed because its leadership did not adapt quickly enough and allowed Netflix to completely take over its market share through its personalized, low-cost streaming service. Similarly, Amazon’s e-commerce business model is not easily replicable by companies like Walmart, Macy’s, or JCPenney, which is why it remains a powerhouse today.
We’ve uncovered many different methods for finding undervalued stocks. Hopefully, you’ll be able to find some that work for you. While this process looks easy on paper, value investing is difficult in reality. Everyone has their personal preferences, so this method may not be for everyone. On a bright note, if you put in the effort to master the art of buying undervalued stocks, you will set yourself up for high returns with limited downside.