U.S. Markets closed

How to Spot an Undervalued Stock

Rebecca Lake
Value investing is an important strategy for long-term investors.

Investing in undervalued shares could give your portfolio a boost if they eventually see significant price appreciation. The concept of value investing, developed by Benjamin Graham and popularized by Warren Buffett, essentially means investing in shares that are undervalued by the market. When a stock’s share price is well below its intrinsic value, that can be a bargain buy for investors. The payoff comes when that stock’s price begins to rise as the market catches on to its true worth. Investors then have an opportunity to sell, ideally for a sizable profit. This is the essential goal of investing: Buy low, sell high. The question is, how do you find undervalued shares to invest in?

How to Identify an Undervalued Stock

Finding undervalued shares to invest in requires some skill and know-how when it comes to how the market works. It also requires a discerning eye, since sometimes shares can appear to be undervalued when they actually aren’t. In that scenario, you might purchase a stock on the assumption that its price will increase over time, but it doesn’t. Instead, the price flatlines or worse, decreases, meaning you realize a loss rather than a gain on your investment. This is known as the value trap.

That’s what you want to avoid with a value investing approach. With that in mind, here are four ways to accurately spot undervalued shares.

1. Check the Ratios

Several ratios can be useful in assessing a stock’s value. Here are some of the most important:

  • Price-to-earnings ratio (P/E). The price-to-earnings ratio is a way to measure a stock’s relative value. It’s the ratio between a company’s share price and its earnings per share. Earnings per share is calculated by dividing a company’s profit by the total number of outstanding shares issued. A higher P/E ratio generally means a higher stock price, relative to the company’s earnings. If a company has a lower P/E ratio, on the other hand, means a stock is less expensive and could be a discounted buy.
  • Price-to-earnings growth ratio (PEG). The PEG ratio is a company’s P/E ratio divided by its earnings growth rate over a set period of time. A low PEG may suggest that the market is discounting a company’s potential to grow over the long-term, resulting in an undervaluation.
  •  Price-to-book ratio (P/B). The price-to-book ratio is a stock’s price divided by its equity per share. When this calculation results in a number that’s less than one, it suggests that the share is trading for less than what the company’s total assets are worth.
  • Current ratio. The current ratio is commonly used to assess a company’s financial health. It’s simply a company’s assets divided by its liabilities, and it’s a way to measure how easily a company can keep up with its debt obligations.
  • Debt-to-equity ratio (D/E). The debt-to-equity ratio means the amount of debt a company has divided by its shareholders’ equity. A higher D/E ratio means a company relies more heavily on debt than equity to finance operations, but that should be balanced against assets, cash flow and earnings when determining value.

2. Consider Cash Flow and Dividend Yield

Cash flow is an important metric to keep tabs of.

Some companies pay investors a dividend, which represents a share of profits. The dividend yield and current cash flow can also be significant when trying to find undervalued shares to invest in.

In terms of dividend yield, it’s important not to be distracted by the number alone. A strong dividend yield suggests that a company is paying out a decent amount of profits right now, but you have to dig deeper. Specifically, you should be looking at a company’s cash flow, debts and dividend payout history to determine if the current dividend yield is sustainable.

If a company is paying the bulk of its profits out in dividends, for example, that may leave it with less cash flow to pay off debts or invest in growth for the long-term. When it comes to finding stocks that are undervalued, the key thing to look for with dividend yield and cash flow is consistency. If a company is continually paying out a steady dividend, despite a lower share price, that’s a sign that its underlying financials are strong.

3. Compare Competitor Pricing

Another way to evaluate whether a share is undervalued is to look at similar companies in the same industry. Here, you want to make apples-to-apples comparisons between the company you think is undervalued and other companies that sell at a higher price point.

Specifically, consider what’s driving the company’s share price to be lower than the competition and how the price is trending. This is where looking at things like the moving average can be helpful. The moving average is a way to track price movements over time, accounting for both short-term and long-term pricing changes.

When looking at pricing trends, keep the drops in perspective and look at how the stock is trading relative to competitors. Also, it’s worth considering whether a competitor company is accurately valued. It could be that a competitor is overvalued, making the company you’re interested in appear to be worth less than it actually is.

4. Look at the Financials

Candle-stick charts can indicate a share's intra-day volatility.

When trying to find undervalued shares, it helps to have as complete a picture of the company’s financials as possible, not just a picture of metrics like the price-to-earnings ratio. That means reviewing the fundamentals concerning things like the income sheet, balance statement and quarterly earnings reports.

Looking at these things can help you get a better sense of how strong the company’s financial position is and how sustainable the business model is. A company that’s seeing steady positive earnings over a multi-year period with minimal debt, for example, could be a good candidate as an undervalued stock if those indicators aren’t reflected by an increasing share price. In other words, the shares could prove to be a dark horse whose potential isn’t being realized by investors.

Something else to consider is how strong a company’s financial position is, relative to its competitors. Specifically, you’d want to look for companies that may be undervalued but have opportunities to grow if a market downturn happens. These are the companies that have strong cash flow, minimal debt and are positioned to see steady or increased demand for their services or products in changing market environments.

The Bottom Line

Picking undervalued shares takes some effort. The better you understand the basics of how to identify stocks that may be undervalued, the easier it may be to use a value investing strategy to boost your portfolio’s return profile. The key is remembering that there’s no definitive set of rules for identifying the right shares to invest in and that like anything else, there’s still a certain amount of risk involved.

Tips for Investing

  • Consider talking to your financial advisor about whether value investing is the right strategy for you and how to employ it in your portfolio. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • If you’re trying to screen which stocks to invest in for value, numerous online tools can help. For example, if you’re investing through an online brokerage account you may have access to stock screeners or other analysis tools that can help you narrow down the field of what to invest in. These tools can help you view key ratios and financial information for different companies at a glance for easy comparisons.

Photo credit: ©iStock.com/porcorex, ©iStock.com/Kateywhat, ©iStock.com/Maximusnd

The post How to Spot an Undervalued Stock appeared first on SmartAsset Blog.