There are many competing investment theories about how to find the “best” investments based on your time frame, risk tolerance and specific objectives. One approach, dating back at least to Benjamin Graham’s 1949 book, The Intelligent Investor, is to identify “undervalued stocks” that for one reason or another are selling at prices far below their underlying values.
Undervalued Stock Indicators
But how can you identify undervalued stocks? There are six criteria investors look for:
Low price/earnings ratio.
No discussion of stock prices would be complete without referencing one of the most common, but not always the best, measures of a stock’s relative value: the price/earnings (P/E) ratio. Every company has a P/E. The higher the P/E, the higher the price of the stock relative to the earnings (profit). While a relatively low P/E ratio may indicate a buying opportunity, it’s important to remember there is likely a reason for the low P/E. For example, a company might report high earnings, but professional investors, who follow the business closely, know the company isn’t telling the whole truth. As a result, the stock price will remain low and the P/E ratio will look appealing. These scenarios are rare, however, so you should be OK to rely on the P/E ratio to find deals.
Lagging relative price performance.
If a company’s share price is lower than those of its industry peers, this may reveal an underperformance situation. This could happen for several reasons. One example is if stock analysts show concern over certain financial metrics (like the ones listed below). It’s not unusual for a single voice on CNBC or in The Wall Street Journal to cause a whiplash effect as investors sell off and drive the price down. What happens is investors drive the price too far down, to the point of making the stock price undervalued. In the screener you use, there will be an option to compare individual stock price histories over various periods of time against other individual stocks and against stock indexes.
Low price/earnings growth ratio.
The price/earnings growth (PEG) ratio is considered more accurate than just a company’s P/E alone. When you’re looking at a stock, take the P/E ratio and divide by the “earnings growth rate.” If the ratio is less than 1 (e.g., a P/E of 10 and projected growth of 15%, giving us a PEG ratio of 0.66), investors may be giving more weight to past performance than to future growth opportunities. Be aware that growth projections are just that, however: projections.
High dividend yield.
Bet you didn’t think to look at the dividend yield, did you? But actually, if a company’s dividend payment rate exceeds that of their competitors, this may indicate that the share price has dipped to “undervalued” status (in relation to its dividend payment). If the company is not financially troubled and future dividend payments appear secure, the dividend opportunity can provide returns in the short term, as well as potential for the stock price to move higher in the future. If you’re using a stock screener (see below), use the “dividend yield %” to find undervalued stocks in a given industry.
Low market-to-book ratio.
A company that has a low market value (total market capitalization) as a ratio to book value (total shareholder equity) may present an undervaluation situation. The key is understanding the real value of both tangible assets (land, buildings, cash) and intangible assets (goodwill, intellectual property). For example, a company that produces and sells toys might also own property. The value of the property the company owns could potentially be worth more than the toy business it operates. Investors might overlook this and the price of a stock will not reflect the underlying value of assets the toy company has on the books.
Free cash flow.
Many investors put less emphasis on reported profit and more on free cash flow — the amount of cash generated by the business after all expenses are accounted for. A stock that appears low-priced because of lower reported earnings may be a great deal in terms of cash flow. You can find this from inside a screener or through your brokerage firm by looking for the cash/share ratio. It can be fascinating to see how two apple-to-apple companies differ in terms of cash on the books.
These metrics aren’t the be-all-end-all to determine if a stock is a good value. No single metric or measure can ensure an investor that a potential investment is undervalued. If several of these seem to be confirming an undervaluation situation, however, you may have identified a market inefficiency that is a good investment opportunity.
Tools for Finding Undervalued Stocks
These days, there are free online tools that provide investors with the ability to search and screen investment ideas within seconds. You can start with a stock screener, such as Google Stock Screener or Yahoo Stock Screener. If you want more in-depth search capabilities and don’t mind paying a few bucks, you can use YCharts’ Stock Screener. With a subscription to YCharts, you’ll also get access to many other investing tools.
Or if you have a brokerage account, I’d recommend using its screeners. What these tools do is analyze the financial metrics of thousands of companies and deliver to you the ones that meet your input. For example, if you input “P/E must be lower than 15,” the screeners will not show you any companies with P/E ratios higher than 15.