The best way to make money when trading stocks is to look for undervalued ones. An undervalued stock is trading far below the market stock price. Something that represents a good deal.
When you find an undervalued stock on the stock market, it is a cheap stock with the potential to make huge gains. You are not looking for instant earnings. Your investing strategy is going to be focused purely on future earnings.
So, how do you identify undervalued stocks? Do these undervalued stocks exist? Let’s take a look.
Is It Possible To Find Undervalued Stocks?
Yes. However, you must remember that other people are looking to find undervalued stocks too. In fact, for many people, it is their job.
This means that you have to think about whether you have found a company’s stock that is undervalued or whether that stock price isn’t worth touching. This can be incredibly difficult if you have no experience purchasing undervalued stocks. It can pretty tricky even if you do have experience finding undervalued stock.
You must remember that every trader is looking for cheap stocks in undervalued sectors. This is how they make their money. It is incredibly uncommon for you to randomly find undervalued companies that can deliver huge returns, particularly if you have never looked.
This page will share tips and tricks on finding individual stocks that could deliver massive gains for you. However, remember that only so much information can be shared here. There is no guarantee regarding a company’s share price, and while something may appear to be undervalued, it may not always pay off in the long term.
What Makes Undervalued Stocks?
Before we talk about how to find undervalued stocks, we want to look at a few factors that could make the market price for the stocks undervalued.
Poor Market Conditions
The are countless companies listed on the stock market. These companies will be broken down into general ‘niches’ e.g. tech, automotive, retail, etc.
When there is a significant change in one of these ‘niches’, you will often find that the market value for all of those companies, even tangentially tied to that industry, will fall, particularly if a larger company sees its share price fall.
This can cause a knock-on effect that may create undervalued stock. For example, let’s say that the automotive industry is going through a big change. You may see gas-powered vehicle producers see their vehicle sales fall. This causes their market value to fall. The companies producing electric vehicles may also see a fall in their market value, even if the factors influencing the gas-powered vehicles are not impacting them.
This creates undervalued stock. Something likely to bounce back when the market turns around and says, “hey, this part of the industry probably isn’t going to be impacted.”
Looking for these market changes is probably the number one method for finding undervalued stocks.
Unexpected Changes In The Business Model
Sometimes companies deal with an unexpected change in how their business operates.
As this article is being prepared, the WWE (a major wrestling promoter) lost its CEO, who has been around since its inception. This was unexpected, and the stock fell as a result. The market had no idea whether the company could survive the loss of that CEO.
Guess what happened? The market rebounded when it very quickly realized that the company could get through without that CEO, and it may end up being stronger than it had been in a long time.
When you are finding stocks, you may want to look at these companies that have gone through a rapid period of change like this. They tend to be undervalued.
Strong Balance Sheets
In theory, the company’s financials should lead to a fair price on the stock market. However, this isn’t always the case. Many investors don’t always deeply dive into the company’s financials.
If a company has a strong balance sheet but a low stock price, then this could indicate that you are looking at one of the many undervalued companies.
Good Cash Flow
A company with good cash flow (and low debt to equity ratio) is, in many cases, going to be an undervalued stock.
Companies with low debt and vast cash flow tend to be stable companies for the future. They also tend to offer a good dividend yield for those looking for quick cash back.
Strong Financial Outlook
What does the company’s earnings growth rate look like? Well, with the undervalued companies, the growth may appear slow in the short term. Many investors are looking for rapid gains. The only future performance that they care about is immediate. They aren’t considering the potential market price in a couple of years.
However, if there is a potential for massive growth in the industry, the current stock price may be undervalued. Again, we want to point out that when you are value investing, you are not looking for short-term gains. You are looking to make gains over a more extended period.
How To Identify Undervalued Stocks
Now we have discussed the absolute basics of undervalued stocks, we can start to help you become a value investor. We want to discuss how you can identify when a stock’s share price may be undervalued.
Remember, we can only give a guide to identifying an undervalued company’s stock price here. While the stock market can lead to financial freedom, you can’t always get it right. You could identify a great company with extraordinary sales growth, but that doesn’t mean the sales growth will continue. A variety of factors could result in undervalued stocks losing their value.
Use Stock Screeners
Any person looking to buy undervalued stocks will need to trawl through countless companies looking at various factors, including the P E ratio (we will discuss that in a bit more depth soon!)
It takes a lot of time, and it could easily take a value investor days to find a stock to their liking if they are doing it manually.
This is why we suggest that you use a stock screener. The job of these stock screeners will be to crawl through countless companies for you.
When you use a stock screener, you will identify what you are looking for in a stock. The stock screeners will then identify markets that you may be interested in. You can then do further research.
The benefit of using a stock screener as a value investor is that a lot of the hard work is going to be done automatically for you. This means you do not have to waste time looking at companies with poor intrinsic value.
Most stock brokers will have stock screeners, sometimes for free. If you seek independent financial advice, then they may even have a stock screener that you can use to find stocks with market-beating returns.
The Price to Earnings Ratio
One of the most important metrics you can use when searching for undervalued stocks is the price-to-earnings ratio, or P E ratio, for short.
To work out the P E ratio, we need two pieces of information:
- The market value of a share
- How much money is the company making per share?
We then divide the first number by the second number. Let’s give a simple example:
- The share price is $120
- The company is making $5 per share
This gives us a P E ratio of €24.
If you don’t know what the EPS is, plenty of sites will tell you! The information isn’t hard to find, and it will look at the last 12 months of information. Although, long-term investors may need to look at the last 20-30 years of EPS, and severe value investors will want to look at the expected EPS that the company in question will release regularly.
Now, the P E ratio won’t work on its own. The P E ratio of $24 that was just given means nothing unless you compare the P E ratio to other companies in the same industry. When you compare the P E ratio to other companies in the same industry, you will get information about whether a stock is overvalued or undervalued.
For example, if we see other companies in the same industry with a P E ratio of $26 regularly, or even $27, this would indicate that the $24 P E ratio is undervalued. It means that there may be an opportunity for growth.
Ideally, the most undervalued stocks are those that trend below the $20 mark. Anything higher than that, the stock price tends to be pretty well valued. However, you will want to compare the P E ratio to other companies in that industry, just to be sure.
Free Cash Flow
The next thing you want to look for is free cash flow.
Free cash flow is the net income of the company. So, the company’s money comes in, minus operating expenses, etc.
Free cash flow is often one of the first indicators that a company may be undervalued.
If you notice that the free cash flow for a company is going up, but the share price isn’t moving in line with it, then you likely have an undervalued stock.
Companies with a good cash flow indicate they are great at generating money. Companies with a high free cash flow tend to have a good dividend yield, which is excellent for short-term money-making when you start in value investing.
Remember, a high free cash flow indicates that future earnings will be high and intrinsic value in the share price. After all, good cash flow means investing more cash to grow the business. It provides a company with more financial freedom.
The PEG ratio is seen as an extension of the P E ratio. It gives a bit more information on a company’s future growth and can be a valuable tool if you are trying to find undervalued stocks.
As you know from before, the P E ratio will give you information on the ratio between the current and past earnings per share in the company. The PEG ratio looks at the projected future growth for the company.
With the PEG ratio, you start with your P E ratio. You will then divide this number by the EPS growth rate, which you will need to find from expert analysts. It may sometimes be included in literature released by the company, but looking for information from growth analysts will be your most accurate source of information.
If the PEG ratio is below 1, you have an undervalued stock. If it is 1, then the stock is around the right price. If it is above 1, then expect the stock’s price to fall in the future.
Value investors should only ever consider stocks with a below 1 PEG ratio. Although, of course, you can compare to similar companies to see how different the ratios are. In rare cases, above 1 could indicate a good stock for value investors.
Debt to Equity Ratio
The debt to equity ratio will inform us how much funding a company gets from loans and how many assets it has. To work out the debt to equity ratio, you will need the following information:
- Shareholder equity
Divide the first number by the second. This will give you the debt-to-equity ratio.
There is no one ratio that you want to be looking for here. This is because the debt-to-equity ratio will need to be judged by the market. So, look at the debt-to-equity ratio for similar companies.
If a company has a low ratio figure compared to similar companies, then this indicates that it has less debt. This means that the company may be undervalued.
Price To Book Ratio
The book value is calculated by the following:
- Assets minutes liabilities.
- Divide this number by the number of shares issued.
To work out the price-to-book ratio, you will need to do the following:
- Divide the market price per share by the book value.
If the number is under 1, then this indicates that a stock price could be undervalued. Too much over 1, then the stock is likely overvalued and will fall unless the company’s book value climbs.
Look At Small Cap Stocks
That’s it for the financial ratios. We get that they can be somewhat confusing, particularly if you are one of the new value investors. However, we aren’t entirely done with helping you to find stock ideas for your value investment.
Generally speaking, we steer clear of large-cap stocks. Large caps tend to be quite risky. The price per stock is relatively high, and they seem to have found their ‘value’. The stock’s price can rise, but you tend to have many talented investors looking at them, so it may not be worth your time.
Instead, you will want to look for your stock ideas in companies with a low total market capitalization. This indicates that there could be high growth in the future.
Finding the market cap shouldn’t be too difficult. Every share trading website will use it, and you can also use a popular free stock screener to find this information.
A low market cap will help find undervalued stocks, but you will still need to look at some of the other metrics we have discussed here to determine whether it is a stock with the potential to grow. Sometimes, the stock’s price is low for a reason.
Look At Emerging Industries
The best-undervalued stocks will always be found in emerging industries. You need to look at the industries which are going through a period of growth or new players in the industry.
For example, a couple of decades ago, social media didn’t exist on the stock market. When social media companies entered the market, you could expect they would grow in value, perhaps not as much as they did, but the emerging industry was there.
We suggest that you only look at emerging industries that you understand. It will give you more of an idea as to whether you can expect that industry to grow or not.
Look At Falling Markets
Remember earlier when we said that falling markets could be a leading cause of undervalued stocks? When you are value investing, you need to look at these falling markets.
Look at individual companies when an overarching market falls. Identify those that may be able to weather the storm or had a stock price that unfairly fell.
We suggest you keep an eye on low-cap companies with good free cash flow here. These tend to be undervalued stocks.
However, you may also want to look at those stocks that may not be falling as sharply as other companies in the industry. This could indicate that other investors see a strong earnings growth rate here, which could be suitable for value investing.
Read The News
When you are value investing, you should constantly be updated on the news. We aren’t just talking about financial news here. Just about any news can impact the stock market.
Use the news to identify emerging markets. Look at new deals being forged. Identify when a market has the potential to fall temporarily. Look for changes in foreign policy.
All of this information can aid your value investing, as you will be guided towards markets that have potential.
Only Ever Focus On Markets You Understand
It doesn’t matter whether you are value investing with undervalued stocks or doing general stock investment; it is essential that you only ever invest in markets that you understand. For example, if you don’t understand tech, then don’t invest in tech.
For starters, investing in markets you understand will make finding stocks easier. You won’t have to look at the whole stock market. You are just looking at a small selection of businesses. It makes your job easier.
The most important thing, however, is that you will know when to enter and exit a market. For example, a stock may appear undervalued, but if you know an industry, you may realize that the market is probably not going to recover in the near future, which means that the investment isn’t a good one to make.
We also find that investing in markets we understand tends to be much more enjoyable. After all, you will read a lot of news and financial reports.
Value investing isn’t easy. It is incredibly difficult. It requires a lot of research, and you will often need to wait a long time to see a substantial return on your investment. However, the potential returns could be huge if you value investing correctly. Good earnings growth could lead to a serious boost to your bank balance.
Remember, stock investment is never going to lead to guaranteed riches. However, the more research that you pour into finding those undervalued stocks, the more chance that you have of making some serious money from your investments. In act, finding undervalued stocks is the key to getting rich on the stock market, particularly if you have little cash to invest.