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Since its inception, finding and discovering undervalued stocks has been the most reliable way to consistently outperform the stock market.
The idea is simple and is the same concept employed by essentially every stock investing strategy: Buy low and sell high.
But, the similarities end there.
The time to buy and the time to sell are determined by the value of the company in question.
If the company is undervalued, you buy and wait for the market to correct its mispricing.
Then, you sell and repeat the process.
For example, you think stock ABC is worth $100 per share but is currently trading for $70. You would consider it undervalued, buy it, and wait for the market to buy it up, accurately raising its price to $100. Then, you would sell and repeat with new stock.
By the end of this article, you will have an idea of a method and/or a set of tools to determine which stocks you consider undervalued, and no longer rely on the stock picks of outside sources.
What are Undervalued Stocks?
To be considered undervalued, a stock must be trading with a price lower than its real — ‘fair’ — value.
Typically, this involves looking at a particular company and comparing its price to its major competitors in its industry.
- Is it trading for a lower price, relative to its merit, than its peers?
- Is it because this company is undervalued?
- Or is it because its competitors are overvalued? How do we determine value?
It all comes down to looking at the fundamentals.
What is Fundamental Analysis?
Performing due diligence on a company’s financial statements and resulting metrics is known as fundamental analysis. Using a variety of different valuation models, professional and retail investors alike heavily rely on fundamental analysis to guide their investment decisions.
The basic philosophy behind investing based on fundamental analysis is that a company’s stock price is not always reflective of its intrinsic value.
The business may have a price well higher or well lower than it deserves.
Our mission is to determine which stocks are trading at discounts to their fair value.
For many years, that was the case for Domino’s Pizza (NYSE: DPZ). From 2007-2012, the stock price remained flat, despite the blossoming underlying fundamentals.
Since 2013, the stock has returned a whopping 1,300%.
The patient, value-seeking investors who got in early and waited have been richly rewarded.
3 Ways to Find Undervalued Stocks
When it comes down to it, there should be no guesswork involved in investing in undervalued stocks. You are making investment decisions based on the information you’ve gathered and the expectations you have about the future.
No single metric can make a company undervalued — it’s always a combination of factors.
The more factors that point in the same direction, the better the evidence you’ve found a winner.
Here are 3 ways you can find an undervalued stock:
#1: Financial Ratios
Ratios are by far the most common tool used by investors to spot value.
Most frequently, investors use ratios to compare a company’s ratios to its industry competitors.
Some of the most common financial ratios are:
- Price-to-earnings (P/E) ratio
- Price-to-earnings growth (PEG) ratio
- Price-to-book (P/B) ratio
- Dividend yield
- Return-on-equity (ROE) ratio
- Price-to-free-cash-flow (FCF) ratio
- Current ratio
More than likely, you’ll find one of these metrics to be more useful in your own analysis than the others, and make it your primary indicator for sifting through and spotting value.
Still, be sure to evaluate multiple metrics before making an investment.
Beyond these, also consider revenue and earnings growth as important indicators of the health of a business.
An outdated, unprofitable business should be cheap — that doesn’t make it undervalued.
#2: Negative Press
Unflattering news about a CEO or official, disappointing earnings, political or social changes — there are a variety of press events that can send even the strongest stocks tumbling.
Oftentimes, the actual underlying business hasn’t changed all that much.
Stock prices are largely driven by human emotions.
Yes, exuberance can drive a stock price higher than it’s worth.
But emotions usually work to the detriment of stock prices, given that we are more prone to avoid pain.
This plays out when we abandon an investment at the first sign of trouble.
For value investors, these events offer prime opportunities to buy great companies at very reasonable prices.
#3: Market or IndustryWide Crashes
Similarly, market crashes or corrections will cause almost all stocks to fall in unison. Take March 2020, for example.
When news of COVID-19 suddenly turned very sour, the market fell roughly 30%, taking all stocks with it.
Though not falling as hard, shares of Netflix (NASDAQ: NFLX) dropped about 10% over the same period, even though COVID itself was good news for the company’s business model.
Investors who saw the discrepancy early were richly rewarded in the following months.
If you find a stock that combines two or all three of the above, you may be one of the first to discover a deep value play.
In this case, and with most value investments, you will need to give the market ample time to correct for its mispricing.
The Bottom Line: Undervalued Stocks
If you don’t know where to start to deploy this new knowledge, perform some analysis on your current portfolio.
What do you notice?
Are you holding undervalued stocks, relative to others in their industries?
By doing this, you can gain valuable experience running through the valuation process and simultaneously double-check that you don’t need to make any adjustments to your investment portfolio.