How to Find Undervalued Stocks

Value of stocks

How to Find Undervalued Stocks

When investing, the goal is to grow the capital put towards the investment. However, this is not always the case, with investments not going as planned and seeing negative returns. One key to being a successful investor is having an investment strategy in place and sticking to it. This article will go through how to find undervalued stocks, which are a strategy with a history of rewarding many investors.

Before going further, take a moment to think about this question: are positive returns within an investment portfolio based on when a stock is bought or sold?

The answer to this question may surprise you; it is when you buy the stock. So here’s the follow-up question: if you are deploying capital into an investment, how can it affect your investment returns?

Let me give you a scenario. Let’s say one day you decide to buy a stock and it happens to be trading at an all-time high. Then, once you have your order filled, the stock starts to drift lower and this trend continues as time passes. Therefore, there will not be an opportunity to sell at a higher price and you will have to choose between holding onto the shares in hopes of a higher price or selling at a loss.

There is one quote that is often used when it comes to investing: “buy low and sell high.” One way to achieve this is by buying undervalued stocks that have catalysts to drive the stock price higher. When buying an undervalued stock, it is being purchased at a discount.

But investing in stocks requires more than getting advice from another investor or simply just looking at a stock chart. This is why it is important to take the time to go through a company because there could be a big payout in the future.

One means of determining if a stock is undervalued is the price-to-earnings (P/E) ratio. This ratio is calculated by taking the current trading price of a stock and dividing it by the annual earnings of the company.

This ratio is most useful when it is compared to the industry average, because if a sector is undervalued, most the companies tend to be in the same boat. If the industry has a high P/E and there is one stock from the group with a lower one, there must be a reason why. This ratio also gives insight on how much of a multiple is being paid for the companies earnings.

The company’s P/E should also be compared to the S&P 500 index because it is a broad-based index with businesses from a variety of sectors. The S&P 500 is used because the companies within the index are considered some of the largest in the world and are traded very frequently, meaning investors are well aware of them.

Another metric for learning a stock’s value is the price-to-book (P/B) ratio, calculated by taking the current market price of a stock and dividing it by the book value per share. The book value per share represents the value of the entire business if it was liquidated and all the outstanding of the debts were paid off and is adjusted on a quarterly basis..

There are two methods of using this ratio. The first is by comparing the current trading price to the book value per share. If this ratio is 1.0x, then it means that the current share price is trading at the same value as the business if it was liquidated. Further, investors have not assigned a premium for the company’s products, land, or intellectual properties. If the P/B is below 1.0x, then it means that the market is discounting the current value of the company and believes it’s not even worth the liquidation value.

Using this ratio and making a comparison to its historic P/B is also viable for determining how investors saw the company in the past. Also note that companies in the same sector at times have the same valuation.

By owning undervalued stocks, it actually lowers your overall risk within the portfolio as well.  This is because as time passes, there is a higher likelihood of seeing positive returns as long as future growth is possible. There are times investor will rotation from companies that are overvalued to undervalued ones.

If you happen to come across a undervalued stock and there is no growth ahead, that is the reason for the company trading at that valuation. Such companies that would be identified as “value traps” because their valuation is cheap and there are no growth drivers to give a boost to its P/E or P/B multiples.

When it comes to finding undervalued stocks, the same method should not be used on different companies. Rather, different metrics should be used based on the sector and the growth profile of the company. For instance, if a technology company has a monopoly in its market segment, then investors wanting exposure to the company will bid up the share price, resulting in a high P/E ratio. There is no way to compare the company to its industry average since it is the only company in its market segment.

Below, I will go through how to find undervalued stocks in a step-by-step process. I will use the steps to analyze a company which would offer great value to investors. Further below is list of undervalued stocks.

Simple Way to Find Undervalued Stocks

Step 1: Determine which companies or sectors you are looking to make an investment in, as well as the size of the companies you are willing to own based on their market cap. Take the time to understand the business models and ensure they are easy to understand in the first place. Decide if you want to receive a dividend payment from the company.

Step 2: Once you have narrowed down the companies or sectors, take a look at the financial metrics of the companies, including the P/E and P/B multiples. Using these ratios, make a comparison to the industry average and the S&P 500 index.

This step would require answering a few questions: why is the stock trading at a undervalued valuation? Is there an issue with the sector and all companies within the sector? Is the a problem with the company’s operations and could it be fixed? Is the issue with management?

Step 3: Take a look at the companies’ growth prospects, and ask yourself what will influence their P/E or P/B to trade at a higher multiple. Factors include recent acquisitions, new products being introduced to the market, and/or the performance of the economy.

If there is no growth ahead for a company, then it should continue to be undervalued and the market will stay away.

Step 4: Research the companies’ past and look at how shareholders are treated. Use the dividend history (if applicable), share buyback history (if applicable) share repurchases, revenue, and net income over the past few years to determine this.

Step 5: If you’ve gone through the first four steps and all of them satisfy your personal investment strategy, the last step would be to deploy capital and make yourself a shareholder.

Analysis of a Current Undervalued Stock

Below I will analyze a undervalued stock and go through all the steps mentioned above. I will be using Gilead Sciences Inc. (NASDAQ:GILD) which operates in the pharmaceutical sector, as an example.

Step 1: Let’s say  you are considering investing in Gilead. Upon understanding the business model and taking a look at the market cap, you feel it could fit perfectly within your portfolio. And the company pays a dividend, which would satisfy your needs as a income investor.

Step 2: Go over the P/E ratio of GILD stock and compare it to the industry average and the S&P 500 index. As of this writing, GILD stock has a ratio is 6.88 times, while the industry average is 40.2 times and the S&P 500 has a ratio of 26.55 times.

The reason that GILD is trading at a undervalued valuation is because there was—and still is—a lot of uncertainty. This time last year, it was unknown who was going to reside in the White House, which resulted is investors moving out of the sector. Negative comments made during the campaign trail impacted the whole pharmaceutical sector, and Gilead was no exception.

Another factor is that Gilead is a global company, which could affect its overall tax situation under President Donald Trump. These are issues that are outside of the company’s control and the business itself does not have any problems with operations. Once there is more certainty about the tax situation, investors could return to this sector.

Step 3: There needs to be growth in a company’s earnings, which will lead to investors bidding up the stock price. If there is no growth, then the market will continue to ignore the company.

In the case of Gilead, there is future growth coming from new treatments being released to the public, with more in the pipeline. As time passes and these treatments become available, this segment will require a lower capital investment, which will free up more cash and benefit the balance sheet.

With the release of these treatments, revenue has been on the rise, with no end in sight. GILD stock also sees very large profit margins, with very little required to invest in research and development and other capital projects.

Step 4: GILD stock pays a dividend to shareholders, and it’s growing—a trend expected to continue. Until the market realizes this great investment opportunity, income could be earned.

The company has also been engaged in repurchasing shares. Buybacks leave shareholders owning a larger percentage of the company due to the fewer remaining shares, as well as notify the market that the company believes its shares are undervalued.

A deeper looks reveals that insiders (senior managers of the company) are using their own money to buy shares in their personal accounts. This is further evidence that the shares are cheap and that there is growth ahead, because insiders would only purchase shares because they believe they will eventually trade higher. Keep in mind that these individuals are very familiar with business and have unique information that everyday investors does not have.

Step 5: Ultimately, if you feel comfortable, then an investment should be considered. But if the investment is something you would not be comfortable with, it may be best to look at a different company in the same sector.

Current Undervalued Stocks 2017

Below is a list of undervalued stocks that pay a dividend. As noted above, investors get paid for holding these investments until the market or other investors realize they undervalued based on the P/E ratio.

Company Name Stock Symbol Price-to-Earnings (P/E) Ratio Industry Average
Gilead Sciences Inc. GILD 6.88 40.2
General Motors Company GM 6.2 37.5
AFLAC Incorporated AFL 11.2 23.7
GameStop Corp. GME 6.7 12.7
Carnival Corp CCL 14.8 33.1
 S&P 500 Index  26.55

Below is a list of undervalued stocks based on the P/B ratio:

Company Name Stock Symbol Price-to-Book (P/B) Industry Average
Metlife Inc. MET 0.87 1.4
American International Group Inc. AIG 0.8 2.2
CIT Group Inc. CIT 0.9 1.6
Great Ajax Corp AJX 0.9 2
Ashford Hospitality Trust Inc. AHT 0.8 3.1

Final Thoughts On How to Find Undervalued Stocks

Even after you have gone through all the due diligence steps and feel that the investment is appropriate for you, you still need to be patient in regards to owning the company, at least until other investors realize that the company is undervalued.

Also, when doing your homework, you must feel confident in your decision, even though the markets may not agree with you. Taking the time to research as much as you can about a company is time well spent. Even if an investment is not made, knowledge about the company and sector is gained, which can always be used in the future.

Investing in an undervalued stock will not magically turn it around overnight. This is why I made the above lists, so you, the reader, can potentially earn income in return for your patience.

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