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How to find undervalued stocks: the ultimate guide

By Connor Freitas

Here, we provide the ultimate guide on how to find undervalued stocks – a discipline that heavyweight investors such as Warren Buffett swear by

How to find undervalued stocks: the ultimate guide

Undervalued stocks are the bread and butter of some of the world’s most renowned financiers – Warren Buffett among them. This strategy, known as value investing, centres on detecting shares that are trading for less than what they should be worth and holding on to them until they grow in value.

Although this may sound straightforward, it can be nerve-wracking because it often involves going against perceived wisdom and backing companies that the stock market appears to be underestimating.

Here, we’re going to explore how to find undervalued stocks – explaining the signs that could indicate there is an opportunity, as well as how to maximise profitability.

Finding undervalued stocks: the ultimate cheat sheet

In a way, learning how to determine if a stock is undervalued is much like bargain hunting in a department store. Let’s imagine that you want a new smartphone, which is normally worth $1,000. Black Friday comes along and a store slashes this price tag to $800. When the sale ends and the device’s cost goes back to normal, there’s an opportunity to make a profit.

The challenge for value investors is calculating what a stock’s price should be – and how it compares to current levels. This can be achieved by intensively analysing the company’s books – scrutinising everything from growth, revenue and profitability to cashflow and financial liabilities. Something that’s trickier to do when finding undervalued stocks is to look at the fundamental factors that don’t necessarily have a tangible value, such as the company’s branding and positioning in the market.

Thankfully, some calculations can be relied upon to detect undervalued shares. One of the most common is the good old price-to-earnings ratio. This is established by dividing a company’s share price by the earnings that each share delivers. Let’s imagine that Connor plc is currently trading at $100 per share and recently had earnings per share of $20. This results in a P/E ratio of five. Lower numbers can indicate that a company is undervalued in its current form – or it could suggest that earnings at the moment are above average when compared with earlier financial periods. (A quick reminder: you can calculate earnings per share by dividing total profits by the number of shares in circulation.)

Although this ratio can have its uses, you should always use it in conjunction with other indicators. It’s difficult to deliver concrete numbers for what represents a good or a bad ratio – every company and industry is different – but comparing a business with competitors can deliver a good barometer of how a firm is performing. An extension of the P/E ratio is the snappily named price-to-earnings-to-growth ratio, which – you guessed it – also factors in how revenue is expected to grow in future. Here, a ratio below one could suggest that a share price is lower than it should be given the forecasts for the coming quarters.

Next in determining undervalued stocks, we have the price-to-book ratio. The first step is to calculate the company’s assets minus liabilities and divide this by the total number of shares in circulation – otherwise known as its book value. From here, the current share price is divided by this book value on a per-share basis. A ratio that falls below one could suggest that stock is trading at a rate that falls below what a company’s assets are actually worth.

Another popular technique for sniffing out undervalued stocks is looking at a listed company’s free cash flow. This relates to the money that’s left over once capital expenditure and operating expenses have been paid for. Higher figures can prove a harbinger for growth in earnings further down the line – and in some cases, it can indicate to investors that buyback schemes and dividends may be on the horizon.

You might also consider looking at the company’s debt-to-equity ratio. This divides the firm’s total liabilities by the total amount of stockholder equity. Over at Connor plc, it has $3bn in debt and $600m in equity – a ratio of five – meaning that for every $1 of equity, there’s $5 of debt. Higher numbers can be a cause for concern but if a young company is going through an aggressive growth phase or in an industry where there are high overheads there could be cause for justification.

How to find undervalued stocks: key factors

The art of finding undervalued stocks involves appreciating the factors that cause listed companies to end up in such a position. It could be because the shares have been caught up in a wider correction that’s affecting the entire stock market – or worse still, a crash. Economic figures or political developments that are seen as detrimental to the company could cause an overreaction from traders. Share prices have also been known to take disproportionate tumbles when financial targets from analysts are missed – even slightly.

A crucial thing to remember in this discipline is that, in the long run, the activities of the wider stock market are immaterial. Those who follow this strategy don’t bother themselves with the laws of supply and demand, or buy into the philosophy that shares are always trading at a fair value. They simply believe that the undervalued stocks they uncover will, one day in the future, return to a price that justifies their worth. As Warren Buffett once said: “In the short term, the market is a popularity contest. In the long term, it is a weighing machine.”

FURTHER READING: What is a value trap? And how do you avoid it?

FURTHER READING: 10 trading mistakes to avoid

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