Undervalued stocks - what are they and how do you find them?
Undervalued stocks require some level of expertise to identify. Investors must
know the criteria for growth stocks to increase revenue. A stock is considered
undervalued if the price is lower than what a person would expect to pay for a
stock of similar quality. If the growth potential is high, the stock may be considered undervalued. Undervalued stocks are found frequently in an economic recession, when the Federal Reserve is raising interest rates, or when they simply fall out of favor with Wall Street.
Although an undervalued stock can simply be an opinion by someone who may or may
not have any supporting data, generally there is a strategy behind it that
includes careful consideration of past, current, and future events, calculated
risks, fundamental analysis, and for some, studying stock chart patterns for
technical indicators that would indicate a future stock price.
In general, to determine if a stock is undervalued, evaluate the following:
Calculate the Price/Earnings Growth (PEG) Ratio. To find the PEG ratio,
determine the expected company five year growth. Divide the price/earnings ratio
by the five year growth for the PEG ratio. The stock can be considered undervalued if the calculation yields a result that is less than one. Compare the PEG ratio with other companies. If the ratio is lower than other companies, the stock will be considered undervalued.
Study the Company Business Plan. Study the company’s business plan to determine their potential for growth. Study Historical Data. If the stock is trading below its historical price, then the stock may considered undervalued.
Dividend Yields. Most experts recommend evaluating a stock’s dividend yields to find an undervalued stock. Smaller companies tend to reinvest the dividends into the company to help them build the company. Larger companies tend to pay out their dividends. Experts do not hold much credence on the dividend yields, because they cannot be sure of the company’s business strategy.
Low Trading Volume. Undervalued stocks tend to have a lower trading volume than most. Stocks with high trading volumes have typically been identified by Wall Street. Stocks are typically more fairly valued as the trading volume increases.
Evaluate Profit Margins. One aspect of selecting an undervalued stock is a strong management. If the management is strong, there are typically high net profit margins. This amount is typically the percentage of profit earned from revenue.
Identify Stocks that Underperformed for One Year. Stocks that have a low
12 month relative strength have underperformed for a year or more. These stocks
typically rebound after a year or more. If the stocks rebound before you
purchase, you may miss the opportunity to purchase a stock at a low price.
Evaluate the Debt to Equity Ratio. Companies that are not accumulating debt are typically preferable to companies with excessive debt. Companies that are not profitable or show no signs of profit are typically not good investments.
Evaluate Growth on An Annual Basis. Annual growth rates are typically better metrics than quarterly metrics. Long term trends are typically better indicators than quarterly trends.
Investment Newsletters. There are a few well-known investment newsletters
which provide recommendations of undervalued stocks. A popular magazine and newsletter is Forbes. Forbes Special Situation Survey did 4 times better than the S&P 500 over the past 5 years. If time or experience keep you finding your own undervalued stocks then this may be a better option for you.
Techniques for Identifying Undervalued Stocks
1. Price/Earnings to Growth Ratio and Undervalued Stocks
As discussed, a PEG ratio below one may be an undervalued stock, what does this mean practically?
For instance, a hypothetical XYZ Company may have a Price to Earnings ratio that is 20 times the company’s annual earnings. In the next five years, most experts anticipate a growth in earnings of 12 percent over the next five years. By dividing the earnings by the anticipated growth, the result yields a number of 1.66. This stock would not be considered undervalued and may not be the best time to invest in the stock.
On the other hand, another WXY Company has a Price to Earnings ratio of 30 times the company’s annual earnings. In the next five years, most experts anticipate a growth in earnings of 40 percent. By dividing the earnings by the anticipated growth, the result yields a number of 0.75. This stock would be considered undervalued, and experts would expect the price to increase in the future. The stock that has fair market value would have a PEG ratio of one.
Use of the PEG ratio is recommended for stocks that possess a negligible dividend yield. The PEG ratio does not account for any investor income received. Experts recommend adding any dividend yield to the growth rate estimation when calculating the PEG ratio to give an accurate assessment of the company’s valuation.
For example, this particular XYZ Company stock appears overvalued based upon the PEG ratio or 2.5. This number was calculated based upon a P/E ratio of 12 and a five percent growth rate estimate. This company, however, has a consistent cash flow and returns cash to investors. The PEG ratio may not be an accurate assessment.
2. Benjamin Graham: Architect of Fundamental Analysis (Weak Form) and Value Investing
In Benjamin Graham's strategy, he looks for differences between the value of the stock price and the actual stock price. Once he identified these stocks, he would buy multiple undervalued stocks for his portfolio. He would hold the stocks until they become fully valued. His book, the Intelligent Investor, describes the techniques for identifying undervalued stocks that are trading a discount rate when compared to the Net Current Asset Value (NCAV).
To calculate the NCAV per share, Graham included current assets into the calculation. From that number, he subtracted the Total Liabilities. Divide the result by the number of outstanding shares. Graham considered the result to be the fair value for the stock. If the fair value is different from the current value, the stock is considered undervalued.
Graham would only purchase stocks that were 66 percent less than their NCAV. In Graham’s experience, he recommends that people buy stocks up to 120 percent of the NCAV. In most instances, clients can still make a profit.
For example, experts may evaluate company ABC. In the example, the company currently has current assets of $130.25 million, total liabilities of $68.3 million and 7.22 million outstanding shares.
In this instance, the NCAV will be calculated by subtracting the total liabilities from the current assets. The result should be divided by 7.22 million shares. Using the rule of thumb that Graham set forth, two thirds of the result ($8.58) is $5.66.
In addition to the NCAV, Graham also suggests that investors evaluate the revenue growth, debt-to-equity, earnings and operational cash flow. Good stocks are rarely undervalued. Most good companies are undervalued because of a negative report or other reactions from the public. Graham suggested buying when others are selling and sell when others were purchasing. Warren Buffet was a follower of Graham and used some of his methods to make his fortune.
This strategy is not recommended for medium to large cap stocks. The strategy does work well in other scenarios. For instance, investors who used the strategy between 1970 and 1983 returned a 29 percent annual gain on average.
Another way to summarize Graham’s theory is the Price to Book Ratio (P/B). The Price per Share divided by the Book Value of Equity will yield the P/B ratio. Assets minus Liabilities equal the Book Value of Equity. When the P/B ratio is lower than one, the company’s stock may be undervalued.
A high Return on Equity (ROE), defined as the Net Income divided by the Shareholder Equity, will raise the P/B value of a company. A high ROE and low P/B may indicate a profitable company and a buying opportunity.
Example A: This company has a P/B ratio of 0.50 indicating that the stock is significantly undervalued. The ROE is 31.41 percent with a $58.23 million market capitalization and quarterly earnings of 101.5 percent. The price to sales ratio is 0.07.
Example B: This oil and gas company has a P/B ratio 0.85. The company’s ROE is at 18.71 percent with a $3.27 percent billion market capitalization. They have an earnings growth of 516.10 percent.
3. Finding Undervalued Stocks using Technical Indicators and Semi-Strong Form
Technicians are strong believers in using technical indicators to determine the undervalued stocks. Nearly 75 percent of equity mutual funds on the S&P 500 underperform. Technical analysts rely on mathematical indicators such as the stock’s Relative Strength Index (RSI) and Moving Average. For instance, many believe if the stock is oversold, the RSI will be below 20. This technical indicator is often termed a contrarian indicator because a low reading is actually a positive buying point.
A moving average is a type of technical indicator that examines the average price of a stock over a given period. Experts may suggest buying a stock when the stock crosses the line, because it is a positive sign of momentum. The most common moving averages used are the simple and exponential moving averages. These two averages are often used along with other technical indicators to indicate undervalued stocks.
Technical indicators can show a trend in future price movement when used together. Many investors use Moving Averages, Bollinger Bands and Parabolic Stop and Reverse (PSAR) points in conjunction with one another to determine the best entry and exit points into the market. Trend confirmations may be viewed on Candlestick charts on a daily, weekly, or annual basis. Using only one technical indicator can yield a false negative. Use all of the indicators together for a more accurate assessment.
Most online stock brokers will provide basic charting software that will have these indicators. The more advanced stand-alone stock charting software
such as Equityfeed
(stock chart shown above) will allow a trader to customize these settings and some have pattern recognition capabilities to help identify stocks that are undervalued.
Technicians tend to solely evaluate the market is based upon price trends. The market is efficient in their mind. In practice, many investors use what is termed in the investment world as “semi-strong form.” Investors using this form incorporate information from earnings reports, news announcements, SEC filings and annual reports to make decisions about stock purchases.
Market efficiency is a huge determinant in whether or not a stock will be undervalued or oversold. Aswath Damodaran “defines an efficient market as one in which the market price is an unbiased estimate of the true value of the investment.” Deviations above and below market value are rare in an efficient market. By definition, then, undervalued stocks will only be found in an inefficient market. Though in practice, deviations occur, and there are periods when stocks are undervalued and overvalued. Investors are able to outperform the market based upon the inefficiencies. In this instance, software and mathematical analysis can indicate entry and exit points into the market based upon the historical information provided.
Undervalued stocks can be a profitable investment for traders that select an accurate predictor for trends in the market. Consider undervalued stocks to improve your trading. A diversified portfolio can help protect against significant losses in the market.