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3 Signs a Company is Undervalued

By Andrew Tonner – Mar 27, 2016 at 2:38PM

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We're looking at real world examples from and IBM to show how some stocks can be seen as cheap, while others can prove patently overvalued.

Everyone loves a deal, and investors are certainly no exception. But finding undervalued stocks can prove a frustrating experience for even seasoned investors, let alone those still learning how to fully dissect financial statements.

Thankfully, these three markers tend to be pretty good indications a company is indeed undervalued.

Insider buying
Who knows a company better than those running it? As such, multiple academic studies have found that high rates of net insider buying, or the difference between insider purchases and sales, serves as a strong indicator that something positive lies around the corner for a given company and its stock. Trading on "material" or meaningful information, like an upcoming earnings beat, constitutes insider trading for the executives at publicly traded firms, so insider buying activity can best be viewed as expressing a general, positive opinion about a company's direction.

So how can investors track insider buying and selling?

The SEC requires all insiders with meaningful ownership positions in a company to fully declare their stakes in a firm. What's more, insiders must file a Form 4 with the SEC for any sale or purchase of a company's shares, which you can find using the SEC's EDGAR online tool.

Stock buybacks
Stock buybacks are in many ways the corporate equivalent of insider buying. The logic underpinning stock buybacks is largely the same. Who is in a highly suitable position to assess whether a company is undervalued? Spoiler alert: its management.

And as should come as no surprise, the empirical evidence demonstrates that, on average, companies that reduce their net number of shares outstanding tend to outperform the broader market in the 12 months following the buyback activity, with especially large outperformance most common among firms that engage in sizable share repurchases.

However, a word of caution is also due here since this is a relatively well-established phenomenon. Companies are free to repurchase their stock regardless of its price, and corporate executives are well aware that the investing public sees stock buybacks as a positive signal. As such, companies that are struggling have in the past been accused at times of using stock buybacks to influence investor perception, rather than engage in disciplined value creation for their shareholders.

Source: Amazon

One recent example that seems particularly fitting was e-commerce giant's (NASDAQ: AMZN) $5 billion share repurchase program, which the firm announced earlier this year. Amazon has a long and deserved track record as one of the most expensive stocks on the market. And though Amazon's shares had fallen some 25% through the repurchase announcement, the firm's shares still remain far from cheap, which brings me to our last valuation marker.

Absolute and relative valuations
News flash -- cheap stocks tend to beat the market, an outcome that has been documented and debated since my undergraduate finance days. Lacking the space or patience for a more thorough analysis of why cheap stocks work here, let's instead focus our efforts on the more useful question of how an investors finds such cheap stocks.

Stocks can be cheap or undervalued in two main ways: either on a relative or an absolute basis. To weigh either of these factors, we need to look at a host of valuation metrics investors often use, which include ratios like price-to-earnings, price-to-book value, price-to-tangible book value, price-to-free cash flow, and many more.

Source: IBM

To further this example, let's take a company I believe might be attractively undervalued at present -- enterprise tech behemoth IBM (NYSE: IBM). To assess whether IBM is undervalued, take its current price-to-earnings (P/E) ratio, which measures roughly 11x. IBM's P/E ratio sits well below both the current and long-term average P/E ratio of the S&P 500 index, which measure 22x (current) and 14x (historic average) respectively.

Not a perfect science
Ultimately, these only represent three methods for examining whether or not a company is undervalued, but these are by no means the only analytical tools investors can, and should, utilize. 

Any investor considering a stock based on its valuation needs to weigh the company's current valuation with its outlook, its competitors, and the market in general, which is why valuation is a far more nebulous endeavor than the simplified analysis provided above. For example, IBM is relatively cheap, but it is also in the midst of navigating a generational business pivot, and the outcome is by no means assured.

However, for investors both veteran and novice, the above items can prove quite useful in finding stocks worth further research for your portfolio.

Andrew Tonner has no position in any stocks mentioned. The Motley Fool owns shares of and recommends We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Stocks Mentioned Stock Quote
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