Value investors look for stocks that they believe are trading below their fair value. If they bet correctly, the stock may soon rise to its fair value, generating a profit.
In the search for potentially undervalued stocks, one idea comes from the "godfather of value investing" Benjamin Graham. Graham was a professor at Columbia Business School who mentored Warren Buffett and wrote several fundamental books on stock analysis.
The Graham Number
Graham created an equation that calculates the fair value of stocks based on two fundamental data points: current earnings per share and current book value per share. The Graham Number = Square Root of (22.5) x (TTM Earnings per Share) x (MRQ Book Value per Share).
This equation assumes that a stock is overvalued if P/E is over 15 or P/BV is over 1.5, and any stocks trading at significant discounts to their Graham number are considered undervalued by the equation. But in choosing stocks, it helps to analyze them beyond their valuations.
Another important angle in stock analysis is market sentiment. Are knowledgeable investors optimistic about a company's outlook? Would you be betting with or against the crowd?
A great guide for sentiment comes from the options market, in which changes in the ratio of outstanding put options to call options (the "put/call") on a stock can indicate whether options traders are becoming more bullish or bearish.
To demonstrate these ideas, we ran a screen on stocks trading at significant discounts to their Graham number that also have seen bullish decreases in put/call over the last 10 trading days.
Do you think options traders believe these names are undervalued?
Use this list as a starting point for your own analysis.
List sorted by change in put/call ratio. (Click here to access other Kapitall articles on the Graham Equation.)
1. Sims Metal Management Limited
2. Prosperity Bancshares
3. Horsehead Holding
4. Insight Enterprises
5. Independent Bank
6. W.R. Berkley
7. Neutral Tandem
9. Webster Financial
10. TTM Technologies
Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.
Kapitall's Alexander Crawford does not own any of the shares mentioned above. Options data sourced from Schaeffer's, BVPS and EPS data sourced from Yahoo! Finance.
The Motley Fool owns shares of W.R. Berkley, Neutral Tandem, and Horsehead Holding. Motley Fool newsletter services have recommended buying shares of Horsehead Holding and TTM Technologies. Motley Fool newsletter services have recommended creating a covered strangle position in TTM Technologies.
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