Learn how to find undervalued stocks by using the right tools and metrics that will allow you to make better trading decisions.
Imagine you could buy a new computer for 40% less than the best price available on the web, just because a company was overstocked. If you are in the market for a computer, you hit the jackpot and benefited from a short-term inventory glut.
This concept of valuation also applies to the stock market. Short-term shifts in sentiment or unexpected financial results can lead to a change in the price of a stock that would provide interest to a value investor.
Beauty is in the eye
When you look for a stock investment, one way to analyze the price is to determine whether it is undervalued based on certain metrics. The general concept behind finding undervalued stocks is analyzing the price relative to profits, growth or assets.
Additionally, some investors use returns and debt to measure valuations.
Why are Stocks Undervalued?
When you search for bargains, such as a computer, you generally look to determine if you are getting a bargain by performing an apple to apple comparison.
For example, you would not compare the price of a MAC to a PC, since these computers are not the same.
There are several reasons that a stock will become undervalued and, in many cases, there is a reason why the price of the stock is falling. Some of the reasons a stock becomes undervalued include:
Understand why stocks become undervalued
- Change in market sentiment or unforeseen news
- Unexpected financial results
- Adverse market conditions
- A shift in the economic cycle
One of the foremost experts on valuing investing, Joel Greenblatt, wrote in his book the “Little Book that Beat the Market” that valuation can change at any time because of a fictitious entity called Mr. Market.
He explains that the market can be fickle and change its mind about valuation from hour to hour, providing investors an opportunity to purchase shares at great values. In Greenblatt’s example, Mr. Market is the sentiment by market participants.
What Greenblatt is referring to is the role that sentiment plays in value investing. Sentiment can change for several reasons including, a shock to the system (such as global pandemic).
During uncertain times, market participants are willing to sell nearly every share they have throwing the baby out with the bathwater. In this type of circumstance, a stock that has a lot of value might be sold for a very inexpensive price.
In addition to a change in market sentiment, the price of a stock might decline due to worse than expected financial results. If a company reports that they missed revenue or profit results or provide worse than forecast guidance, the price of the stock might fall.
Adverse market conditions can also generate volatility which might drive down a stock price to a level that you might consider to be undervalued. Lastly, different sectors will outperform or underperform during an economic cycle.
Generally, in the beginning, cyclical (companies that make discretionary items) stocks will outperform, due to pent up demand, and toward the end of the cycle, consumer staple or more defensive stocks will outperform.
What Determines if a Stock is Undervalued?
There are several metrics that you can use to help you determine if a stock is undervalued. The most pertinent include:
- Price to Earnings Ratio (P/E): To create the ratio you divide the price of the stock by the annual earnings (profits) figure. A low P/E can mean that the stock price is undervalued while a high P/E can mean that a stock price is overvalued.
- Price to Growth (PEG) is a ratio that is calculated by dividing the P/E ratio by the earnings growth rate over a specific period (generally 5-years).
- Price to Book Ratio is calculated by dividing the share price by equity per share. This reflects the value of the company related to the assets the company owns.
- Debt to Equity is a ratio that calculates the total debt liability divided by shareholder equity.
- Return on equity calculates the annualized net profits of the company as a percent of shareholder equity.
Each of the ratios provides you with a piece of information but not the entire puzzle. For example, when you look at the price of a stock relative to the future earnings, you are assuming that future earnings will be in a certain range, which might not come to fruition.
This can distort the P/E ratio. Future growth rates also assume a specific growth rate, which impacts the PEG ratio.
Some stocks can be valued based on their book value, which generally eliminates many growth stocks.
What you will likely find is that each sector of the market can be predicted with several metrics. Growth stocks that are categories as cyclical or technology are tracked closely using the PEG ratio.
Changes in the PEG reflect accelerating and decelerating momentum in growth rates. Historically, banks have been tracked closely by the P/B ratio.
Banks are considered necessities that are governed by tight regulations that mitigate explosive growth. Utilities are tied heavily to interest rate changes as they are viewed as steady and are often valued using a combination of price to earnings and price to book.
Finding value in the stock markets is based on several assumptions. Most of these assumptions focus on future financial results. Price to earnings is the most well-known metrics.
You can use the most recent earnings to evaluate the price, but future earnings are more relevant to market participants. Also, you might consider using ratios such as price to book, price to growth, debt to equity or return on equity to create a valuation for a stock.
Each market sector in the S&P 500 index can be evaluated differently based on market convention.
While growth stocks will be more correlated to the PEG ratio, the valuation of banks will be more suited to the price to book ratio.
A good take away is that there are several ways to measure undervalued stocks and take advantage of market mispricings due to unforeseen events.