How to find undervalued stocks

If you’re new to the world of value investing, you’ll know that it’s about finding undervalued stocks – but what exactly does that mean, and how do you know if a stock is undervalued? In this blog post, we help you understand why stocks become undervalued, how to assess if a stock is trading for less than its worth, and how to find undervalued stocks.

What are undervalued stocks?

Undervalued stocks are stocks that trade for less than what they’re actually worth. Their companies often have strong financials and earnings potential but the market hasn’t recognized their true value yet. This might happen for a number of reasons, including negative press, broader market downturns, or just a lack of investor attention.

You can think of finding undervalued stocks like spotting a good-quality item on sale. If a $100 product is temporarily priced at $80, you might say it’s a good deal. It’s the same concept with undervalued stocks. Investors try to buy strong companies at a discount with the expectation that the market will eventually correct the price.

Note that buying undervalued stocks is different to just buying cheap stocks. The key is to find high-quality stocks with good fundamentals and strong growth potential – these stocks are likely to potentially increase in value over the long term.

Why do stocks become undervalued?

So, how do stocks become undervalued in the first place?

Macroeconomic conditions

Rising interest rates, inflation, or geopolitical tension can trigger market-wide sell-offs. During these periods, even strong companies can be pushed down with the rest of the market. In 2020, for example, stocks like Microsoft and Visa dropped over 30% due to COVID-related panic selling, only to rebound when the economy restabilized.

Short-term market overreactions

Markets often react strongly to bad news, even if it’s just temporary. This can create an opportunity for buying undervalued stocks before they may bounce back.

For example, Meta (formerly Facebook) lost more than 40% of its value in 2018 following a privacy scandal. Despite the panic, Meta continued to grow its core business and eventually recovered in the following years.

Earnings misses or negative headlines

Stocks can also fall after disappointing earnings reports or unfavorable media coverage. In 2019, for example, Starbucks saw its stock drop 10% in a single day after releasing weaker-than-expected sales growth in China. Investors took this as a sign of slowing international expansion and increased competition from Chinese competitor, Luckin Coffee.

But Starbucks continued to expand, and by 2021, the company’s stock had nearly doubled from its 2019 lows. This proves that short-term earnings misses aren’t always a sign of longer-term issues.

Underappreciated growth potential

Sometimes, a company’s long-term growth prospects are simply overlooked by the market. An example of this was seen in 2014-2015, when Amazon was trading at a historically low P/E ratio.

Investors were concerned about the company’s heavy spending on Amazon Web Services (AWS) and believed it was favoring growth over profitability. In time, however, the company’s investment in cloud computing became one of its main profit drivers.

Cyclical downturns in an industry

There are times when an entire sector falls out of favor. When this happens, even the strong companies can see their stock prices drop and become undervalued. In 2020, for example, Enterprise Products Partners (EPD) was hit hard along with the rest of the energy sector.

In the following years, demand for oil and natural gas recovered and EPD’s stock saw a 100%+ 5-year price return for investors who saw that it was undervalued and bought in 2020.

Lack of analyst coverage

Small or lesser-known companies often receive less attention from Wall Street. With less investors aware of them, these stocks can trade well below their fair value and create potential opportunities for early investors.

Key metrics to measure undervalued stocks

Now you know why stocks become undervalued, let’s take a look at how you can measure if a stock is undervalued or not. The metrics below all offer ways to assess whether a stock is trading below its fair value.

Price-to-earnings ratio (P/E)

The P/E ratio is one of the most widely used ways to measure a company’s value. It shows you how much investors are paying for each dollar of a company’s earnings – in other words, how much you have to spend in order to make $1 in profit.

Here’s how to calculate P/E ratio:

P/E Ratio = Price Per Share / Earnings Per Share (EPS)

EPS can be calculated as: Total Company Profit / Number of Shares issued.

A low P/E ratio compared to industry peers may suggest an undervalued stock. For example, in 2023 META had a P/E ratio below 15 despite strong fundamentals. Investors who spotted this saw significant returns in the next few years.

Debt-equity ratio (D/E)

The D/E ratio compares a company’s debt to its shareholder equity. It’s used to gauge financial risk.

Here’s how to calculate D/E ratio:

D/E Ratio = Total Liabilities / Shareholder Equity

Companies with a lower D/E ratio compared to industry peers are considered to be more financially stable since they rely less on debt. This can be a sign of undervaluation.

Return on equity (ROE)

ROE measures how efficiently a company generates profit from its shareholder investments.

Here’s how to calculate ROE:

ROE = Net Income / Shareholder Equity

Companies with a higher ROE are generally considered to be profitable and potentially trading below their fair value.

Earnings yield

Earnings yield is like the opposite of the P/E ratio. It’s used to compare a stock against bond yields.

Here’s how to calculate earnings yield:

Earnings Yield = EPS / Share Price

Earnings yields higher than the average Treasury bond rate might suggest a stock is undervalued.

Dividend yield

Dividend yield measures the return an investor gets from annual dividends relative to the stock’s price.

Here’s how to calculate dividend yield:

Dividend Yield = Annual Dividend / Current Share Price

Companies with higher dividend yields suggest financial stability and stronger value.

Current ratio

The current ratio measures a company’s short-term financial health by looking at its ability to pay off debts.

Here’s how to calculate current ratio:

Current Ratio = Current Assets / Current Liabilities

Ratios under 1 mean that a company’s assets aren’t enough to cover its liabilities, which can suggest financial trouble. The lower the ratio, the higher chance that a stock’s price will continue to fall.

Price-earnings to growth ratio (PEG)

PEG compares the P/E ratio with the percentage growth in annual EPS.

Here’s how to calculate PEG:

PEG = P/E Ratio / EPS Growth Rate (%)

If a company has strong earnings and a low PEG ratio, it could suggest its stock is undervalued.

Price-to-book ratio (P/B)

P/B ratio compares a current’s market value to its book value (assets minus liabilities, divided by the number of shares issued).

Here’s how to calculate P/B ratio:

P/B Ratio = Market Price Per Share / Book Value Per Share

Companies with a P/B ratio lower than 1 may have undervalued stocks, especially if their assets are of a high quality. For example, Bank of America traded below book value after the 2008 financial crisis, even though it held billions in valuable assets and deposits.

How to find undervalued stocks

Finally, let’s look at how you can find undervalued stocks.

Use stock screeners

Stock screeners help you filter thousands of companies to find those that meet specific criteria. For example, you can use a stock screener to filter for companies with a low P/E ratio or high ROE.

Most brokerage platforms have built-in stock screeners and you can also find them on websites like Yahoo Finance or Morningstar.

Explore undervalued sectors and emerging industries

Like we mentioned earlier, sometimes entire sectors can fall out of favor and drag down good stocks along with the weaker ones. For example, let’s say all tech stocks have taken a hit – that will mean there are strong companies within the group that are temporarily mispriced.

You can also find undervalued stocks in emerging industries, like AI or renewable energy. In these cases, investor attention may not have caught up yet to a company’s growth potential.

Although emerging industries may provide potential opportunities for undervalued stocks, they can also be risky.

Follow investing gurus

It’s always worth tracking the moves of legendary investors to see what they’re buying. Some tips for doing this:

• Look for new positions in individual stocks as well as increased stakes
• Compare their positions to current stock prices – sometimes a stock will be cheaper now than when it was first purchased by the investor
• Avoid buying stocks that have already gone up significantly – you’ll likely have missed the undervalued opportunity.

Some popular value investors to watch include:

• Warren Buffet (Berkshire Hathaway): Buffet is known for buying high-quality companies with strong long-term potential
• Michael Burry (Scion Asset Management): Burry takes contrarian bets on deeply mispriced stocks
• Mohnish Pabrai (Pabrai Investment Funds): Pabrai looks for companies trading well below intrinsic value
• David Einhorn (Greenlight Capital): Einhorn targets undervalued stocks with near-term catalysts.

Conduct thorough research

Before you invest in any stock – no matter which legendary investor bought it before you – take the time to understand the business first. This includes reviewing financial statements, earnings history, balance sheet, and growth outlook. You can also read recent news and analyst opinions to expand your understanding of the company and where it’s potentially headed.

Think carefully about why you want to invest in a stock. This ‘why’ will help you stay confident through market ups and downs. And remember Warren Buffet’s advice – only invest in what you understand.

Common mistakes when searching for undervalued stocks

Before we send you on your way, let’s cover some common mistakes:

Falling for value traps

Just because a stock looks cheap, it doesn’t mean it’s undervalued. Some companies trade at low P/E ratios because their business is in decline or their models are no longer sustainable. This is known as a value trap.

For example, both Kodak and Blockbuster once looked like bargain buys, but these companies failed to adapt to changing industries and eventually went bankrupt.

Ignoring future growth potential

Stocks will sometimes trade at a low multiple, but if the company lacks future growth prospects the stock might stay undervalued for a long time. An example of this is IBM, which has traded at a low valuation for years due to sluggish revenue growth.

Overreliance on a single metric

Finally, don’t rely on any single metric when looking for undervalued stocks. Tools like P/E ratio, P/B, or ROE should be used along with qualitative analysis to give you the full story of a company’s performance.