There are many competing investment theories about finding 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.
In this guide, we will look at why a stock may be undervalued and how to find an undervalued stock so you can make the best investment decisions for your goals.
The Short Version
- An undervalued stock is one that you think has an intrinsic value higher than what it is currently trading for.
- Investors use different criteria and methods to decide if a stock is undervalued.
- Some of those methods include looking at various ratios, using fundamental analysis, looking at moving averages, patterns, and more.
What Are Undervalued Stocks?
An undervalued stock is a stock that you believe has an intrinsic value (implied, true value) that’s higher than the current stock market price. For example, say you think stock X is worth $50 per share and currently has a $35 per share market price. Stock X would be considered an undervalued stock.
Every investor and investment manager uses different criteria to decide if a stock is undervalued, overvalued or fairly valued. This often relies on a combination of company financial results, stock market data and recent stock trends, among other factors.
Successful investor Warren Buffett, CEO of Berkshire Hathaway, is a firm believer in value investing, which identifies undervalued stocks that have long-term growth potential. Buffett learned this strategy from his professor, Benjamin Graham — the same Benjamin Graham who authored The Intelligent Investor.
Using a Stock Screener to Find Undervalued Stocks
Any investor would be thrilled to find a stock that’s on the way up in price, but it’s not always a simple or easy process. While you can look at analyst ratings, news reports and other sources, one of the best ways to identify undervalued stocks is using a stock screener. You can find out how to use advanced stock screeners in our guide.
A stock screener is a tool that helps you filter through an extensive list of stocks based on company financial data and other inputs. Thanks to the power of the web, there are many high-quality, easy-to-use stock screeners available. Some are free, though you’ll have to pay for the most advanced features.
Depending on your investment goals, you may use a pre-defined screener or build your own to help you narrow down to a list of the best stocks for your portfolio.
Popular Stock Screeners
Morningstar: Morningstar is a large investment data company, perhaps best known for its rating system for evaluating investment funds. Morningstar also features a powerful stock screener that’s perfect for investors on the hunt for undervalued stocks.
Find out more in our Morningstar review.
Find out more in our StockRover review.
If you’re looking for other stock screeners, check out our best stock screener guide.
How to Find Undervalued Stocks
Successfully finding undervalued stocks takes more skill than throwing a dart at the stock section of the Wall Street Journal. Investors with consistent, long-term success often use a combination of metrics and calculations to pick undervalued companies.
Using Fundamental Analysis
Fundamental analysis is the use of financial metrics and comparisons to determine the target value of a stock. If you believe the target value is higher than the current market value, you’ve found an undervalued stock. Professional and advanced investors often use a combination of methodologies. Some of the most important fundamental analysis ratios and tools used in stock valuations include:
Discounted Cash Flow Analysis: A discounted cash flow (DCF) analysis involves projecting a firm’s future cash flows and using those projections to determine a company’s current value.
Dividend Discount Model: With the dividend discount model, you use a company’s current and projected dividend payments to determine the intrinsic value of a stock.
Comparing the financials of a company to industry competitors to estimate the business’ value. Price-to-earnings (P/E), price-to-book, price-to-sales and other stock ratios are commonly employed. Here is an overview of some of the most common ratios used to identify undervalued stocks:
Low Price/Earnings Ratio: One of the most common, but not always the best, measures of a stock's relative value is the price/earnings (P/E) ratio. Every company has a P/E and 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.
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. Read more about growth stock investing.
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.
Using Technical Analysis
Technical analysis is a short-term valuation method where you predict future stock prices based on recent and historic patterns. Active stock traders use charts and technical analysis tools to look for stocks they believe are on the way up.
Moving Averages: Looking at a stock’s 50-day moving average compared to the 200-day moving average is a popular method of finding stocks that may be a buy or sell opportunity. This is just one of many uses of moving averages and trendlines when looking to profit in the stock market.
Pattern Analysis: Traders use additional overlays to find specific patterns and potential buy or sell points. For example, Bollinger Bands are used to find buy and sell levels using standard deviations and moving averages together.
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. In the screener you use, there will be an option to compare individual stock price histories over various periods against other individual stocks and against stock indexes.
Check out our full article on Fundamental vs. Technical Analysis to learn more.
Using Stock Picking Services
In addition to building your own screeners, you can choose to invest in stocks found through a stock picking service. These services rely on teams of professional investment analysts who help you find high-quality investment opportunities.
Stock picking services may be a good fit for your goals, but keep in mind that any other subscriber has access to the exact same list. That can quickly increase the price of a stock recently recommended by a large newsletter or website. Here are some stock picking services we like:
- The Motley Fool: The Motley Fool is an investment website with several major subscription products. These aim to help you build a portfolio of stocks for long-term investments.
- The Street: Popularized by CNBC personality Jim Cramer, The Street offers stock-picking lists and other financial tools and resources.
- Dow Theory Forecasts: Dow Theory is an investing newsletter with online and offline picks of top stocks, offering well-reasoned analysis included.
Read our best stock picking services here.
The Bottom Line
If it were easy to pick undervalued stocks, everyone would be doing it. But investors with patience and the right strategy may find success beating the market by investing in undervalued stocks.
When investing in any asset, including the stock market, it’s essential to weigh out risk and potential returns so you make investment decisions appropriate for your unique investment goals and experience. When you pay close attention to intrinsic value, you may be on track to find the ideal mix of undervalued stocks to set yourself up for financial success.