How to Find Undervalued Stocks Fast
The value of a stock should be the most important criterion to select a stock. But when investors lose focus and get swayed away by the glittering news, then the inevitable happens. Discovering undervalued stocks is one of the main challanges investing in stocks. How to find undervalued stocks? Investors should stick to the fundamentals instead of listening to gurus.
Investors who chase the “hot stocks” tend to be disappointed by their investment performance. This happens because stocks that get media attention receive many funds from both institutional and retail investors. Hence, these stocks are less likely to be undervalued.
One can’t blame people for taking this approach as analyzing thousands of publicly listed companies is a daunting task. How do we find these hidden gems easily? In this post, we will guide you through a simple four-step process to find safe and undervalued stocks.
Finding promising stocks is not an easy task, and many investors struggle with it. However, there is a process to it and once mastered, finding undervalued gems becomes easy.
There are a large number of stocks on a given exchange. For instance, the New York Stock Exchange (NYSE) alone lists hundreds of stocks and the NASDAQ, even thousands. The good news, online stock screeners, have made our life easy. The screeners allow us to make an independent and rational selection, which is not influenced by emotions.
Cheaply valued stocks with terrible financial conditions are of no use to us. Our aim should be to find cheap stocks with remarkable financial conditions.
Here are some of the criteria I use to screen stocks.
Return on Equity > 10%
Indicates high profitability and have a potential competitive advantage
Debt-to-Equity ratio < 0.5
Implies that the company does not depend on outside capital to finance its growth
Current ratio > 2
The current ratio is basically a liquidity ratio and indicator to assess if a company can cover its short term obligations.
Even though P/E (price to equity ratio) is a popular metric, it is tricky to filter. P/E ratios differ by industry, and hence one should be aware of the potential competition. P/E, by itself, does not say that much about the undervaluation of stocks. A trustworthy company with a low growth rate can still be a profitable investment if the potential is right.
One can check dividend yield as a screener for stocks as well. A dividend yield greater than 1 percent is a good cutoff. This implies that the company has internal funds to sustain dividend payouts. Another criterion I sometimes filter on is market cap < 1 billion. Smaller companies receive less attention from analysts and hence are more likely to be undervalued. It is well-known in the finance industry that small-cap stocks outperform large-cap stocks.
Try out various combinations of filters and read the rationale behind them. Then choose the combinations you become most comfortable with. There are many online stock screeners available, free and paid ones. Use your criteria to select a number of stocks.
Stock Rover is the most powerful stock screener for value investors and fundamental analysts. It is a good stock screener with a user-friendly interface. Stock Rover comes with a 14-day trial and starts as low as $7.99/month in the paid version.
Yahoo provides a paid version called yahoo!finance premium for $34.99 per month and a free version of the online screener to scan for basic patterns.
This is also a popular free stock screener with a good interface. You can do some basic scans filtering the whole stock universe down to a few. Export functionality and advanced scanner metrics are only available in the paid version for $24.96 per month.
GuruFocus provides information about stock holdings of popular investors. It also has user-friendly and unique stock screeners. The premium subscription is available for $449 per year, covering the USA Region.
Subscribe To a Paid Investment Newsletter
The Motley Fool Stock Advisor and Rule Breakers are two of the most popular ones. Newsletters are guidelines and provide information about various investment opportunities. However, it is essential to perform due diligence before investing. Do read up on blogs and follow the financial news. However, always perform due diligence.
2. Create a Watchlist
In the second step, you create a shortlist of stocks. Let say you choose 30 stocks. Once you create a shortlist, the next step is to dig deeper to identify the real gems. You create a shortlist by using various fundamental characteristics of a firm. Here are the indicators, which Warren Buffett uses to screen stocks.
High and persistent net margins are a great sign. This means that a company has a sustainable competitive advantage. It is also essential to check whether a firm generates healthy levels of free cash flow (FCF). If a firm reports decent net profits consistently and is unable to generate FCF, there might be issues with the firm. This kind of dichotomy typically points to earnings manipulation.
Fairly Low Debt
A firm with high leverage poses default risks and inflates the ROE figures. These firms also bear interest rate risks. When interest rates go up, these earnings of these high levered firms will go down. It will make them an unattractive opportunity.
Debt-heavy companies are more likely to get into trouble when business slows down or a negative macroeconomic shock. It is preferable to have a long-term debt to equity ratio below 0.5
Profitable businesses attract competition, and increased competition leads to lower profits. A deterioration in profitability can only be prevented through a sustainable competitive advantage.
Drivers of competitive advantage could be patents, trademarks, network effects, and others.
An experienced, skillful, and ethical management plays a crucial role in guiding a firm in the right direction. Always look at the history of a firm’s key executives and use search engines to find related scams or fraud. Please do the same for the company itself to take a look behind the curtain.
Also, focus on the capital allocation strategy of a firm. Use the following rule of thumb. A company with a consistently high return and plenty of growth potential should reinvest to expand its operations.
If a firm pays a lot of dividends to its shareholders, one might question the long-term business and growth prospects. Also, an investor should keep a close eye on share buybacks. Ideally, management should buy stocks only when it is undervalued.
Easy to Understand Business Objectives
One should avoid complex businesses. Complex businesses are not necessarily outperforming the market. On top of that, the more complex a business is, the harder it is to understand them. Business complexity increases the chances of overlooking red flags.
It’s important to understand the business model of a firm for long-term investing. Reading SEC filings such as 10-K and 10-Q will gradually help to become an expert on business and industry.
Analyzing stocks is a difficult process. However, once you analyze each of the selected stocks, it should be easy to narrow down the list to a more manageable number.
3. Advanced Tactics
The intrinsic value of a company is an unobserved value. This should have been the current price of a stock. However, it is difficult to come up with a single number when so many factors impact stock prices.
Let’s assume that the estimated intrinsic values are reliable, and the price per share is higher than the intrinsic values. Then, the stock is overvalued. We should look for firms whose current stock prices are lower than intrinsic values. The more the firm’s recent stock price is undervalued, the better it is for an investor.
If the current stock price is marginally undervalued compared to the intrinsic value, we should ignore those stocks. The reason is that we should account for the margin of error in our calculated intrinsic value.
The right price is a price that gives you a wide margin of safety. So even if you are off in your estimates, the stock will still generate returns for you. One should look for stocks whose current prices are trading at a discount of at least 25 percent compared to the intrinsic values. Again, this depends on the level of confidence one has on their estimated intrinsic value. 25 percent is a good thumb rule.
There are various methods to calculate intrinsic value, and here are three of them:
This method calculates a five-year price target based on a reasonable P/E valuation. One then arrives at an intrinsic value estimate by taking the NPV. The higher the P/E ratio, the more investors are willing to pay due to growth expectations.
Discounted Cash Flow
It is an accounting-based model. Projections are made for various accounting metrics, such as free cash flow and earnings. The projected future cash values are discounted using a return on capital value to calculate an intrinsic value.
Return on Equity
Return on equity (ROE) is calculated as net income divided by book value. An attractive stock might have an ROE within a range of 15-20%. You can compare the ROE of a given stock to the ROE of other stocks within the same sector to identify valuable investment opportunities.
The last step is to compare the calculated intrinsic value with the current price of the stock. If the current price is below the stocks estimated intrinsic value, then the stock is a good candidate for investment.
Generally, it is rare to find a company trading at a discount with all the characteristics mentioned in steps 1 and 2. The time during a recession is a great time to find such hidden gems, or at any time in an exaggerated bear-market cycle. As business opportunities dry, the stocks trade at a discount. Later on, when the economy goes into the growth period, the undervalued stocks generate huge returns.
Have your watchlist available with your chosen fundamentals and watch their business figures. These stocks might present a buying opportunity when their prices decline and finally meet your criteria.
How To Find Undervalued Stocks: Wrap Up
Finding undervalued stocks can be done in a straightforward process by filtering key financial figures using a powerful stock scanner. Growth stocks and even hidden gems can be found before others do. Price to book ratio, market value, peg ratio, price to earnings, earnings growth, and dividend payments are some things you can filter on besides the outlined ways to calculate the ratio to intrinsic value.
Even some of the best stocks are undervalued at certain times during market corrections. As a result, growth projections can be made, and undervalued stocks can be found. Stock trading and value investing can go hand in hand when investing in the long run. Day traders do not need to think about finding undervalued stocks, but it is crucial for investors.