This article was updated on February 6, 2018, and originally published on May 31, 2016.
If you could buy a $100 bill for $80, wouldn't you jump at the chance to do so? While value investing is a little more complex than that, it's the general concept behind finding undervalued stocks for your portfolio. This sounds like a great idea in principle, but how do you find these amazing bargains? Here's a list of five steps to take in order to find undervalued stocks of your own.
1. Understand why stocks become undervalued
One of the central ideas of value investing is that the market misprices stocks from time to time. There are many potential reasons why a stock can become undervalued, but these are a few of the more common ones:
- Missed expectations: If a stock reports quarterly results that fall short of expectations, shares can drop more than the situation calls for.
- Market crashes and corrections: If the entire market drops, it's a great time to look for undervalued stocks.
- Bad news: Just like when a stock misses analysts' expectations, a bad news item can cause a knee-jerk reaction, sending shares plunging more than they should.
- Cyclical fluctuations: Certain sectors tend to perform better at different stages of the economic cycle. Sectors that are out of favor are good places to look for bargains.
2. Only look at businesses you understand
This should go without saying, but too many investors buy shares of companies without really knowing how they make their money or having a grasp on the overall business dynamics of the industry. As a rule when searching for undervalued companies, I highly recommend narrowing your search for undervalued stocks to the types of businesses you understand.
For example, I have a strong understanding of the banking industry, as well as real estate, energy, and consumer goods, so stocks in those industries make up the majority of my portfolio. On the other hand, I really don't have a good grasp on the biotech industry so I simply won't invest in it. Don't get me wrong -- I'm sure there are a lot of great companies in biotech, and many could indeed be undervalued right now, but it's just not my area of expertise.
3. Know the metrics
There are dozens of metrics you can use to evaluate a stock, but the following are some of the best for locating undervalued stocks:
- Price-to-earnings (P/E) ratio: By dividing a stock's current share price by its annual earnings, you can calculate this metric, which is useful for comparing companies in the same business. A lower P/E means a stock is "cheaper," but this is just one variable to consider.
- Price-to-book (P/B) ratio: Calculated by dividing a stock's price by its equity per share. A book value of less than one implies that the stock is trading for less than the value of a business's assets. Value investors use P/B multiples to find stocks with a margin of safety.
- Price-to-earnings to growth (PEG): Found by dividing a stock's P/E ratio by its projected earnings growth rate over a certain time period -- typically the next five years. This can be effective for assessing the valuation of a company with a seemingly high P/E, but whose earnings are growing rapidly.
- Return on equity (ROE): A company's annualized net income as a percentage of shareholders' equity. This is a measure of how efficiently a company is using invested capital to generate profits.
- Debt-to-equity ratio: As the name implies, this is calculated by dividing a company's total debt by its shareholders' equity.
- Current ratio: A liquidity metric calculated by dividing a company's current assets by its current liabilities. This tells investors how easily a company can pay its short-term obligations.
Once you start evaluating stocks and getting a feel for these metrics, it's a good idea to develop your own criteria for identifying a stock as undervalued. For example, when I'm hunting for a good value, I like to see a below-average P/E for the stock's peer group, a debt-to-equity ratio of 0.5 or less, and ROE of 15% or higher. Note that these aren't set-in-stone guidelines. Rather, they are one piece of the puzzle that should be taken into consideration.
4. Go beyond the numbers
These metrics are a great place to start, but there are other things to look at that can be indicative of an undervalued stock.
For example, one of Warren Buffett's criteria is that a company has a "wide economic moat," which means a sustainable competitive advantage that should protect it from economic downturns as well as from its competitors. Wal-Mart is an excellent example of a company with a wide moat. Thanks to its size and efficiency, it can undercut most other retailers. Therefore, when times get tough and people need to save money, Wal-Mart actually gets more customers. All other things being equal, a company with a wide moat is considerably more valuable that a company without one.
Insider buying and selling is another thing to look at. Basically, if company insiders hold large stakes and are buying more shares, it's a good sign that people on the inside feel there's a good value to be had. While this isn't a foolproof indicator, it's certainly worth looking at.
5. A final rule
The final rule for finding undervalued stocks is to be patient. Sometimes the overall market gets expensive and none of the companies you follow will seem to be trading for attractive values, and that's OK. Bargains will come, so if you can't find an undervalued stock, don't force an investment that you'll later regret.