Finding undervalued stocks has been a time-honored strategy for long-term outperformance throughout the stock market's long history. It is a strategy that entails purchasing stock in well-established companies at a discount to their biggest competitors. When the market recognizes an undervalued company, the returns can be extraordinary.
Consider it a deliberate strategy of purchasing low and selling high. You can buy inexpensively because most other investors are ignoring the undervalued company. However, you can sell high if the market eventually recognizes the stock's value and the price rises due to the stampede of new investors.
However, how do you identify undervalued stocks, especially in today's investment market, where computer investing and trading reflect valuation discrepancies?
An undervalued stock is one that you believe has a higher intrinsic value (implied, actual value) than the current stock market price. For instance, suppose you believe stock X is worth $50 per share and the current market price is $35 per share, and stock X is believed to be undervalued.
Each investor and investment manager utilizes a unique set of criteria to determine if a stock is under-, over-, or appropriately valued. This is frequently determined by a mix of measures, including corporate financial results, stock market data, and current stock patterns.
Fundamental analysis is predicated on the premise that market prices will eventually change to reflect an asset's true value, hence creating profit opportunities. Finding undervalued stocks requires more than simply shopping for discounts; the challenge is to seek out high-quality supplies at a discount to their fair value rather than useless stocks at a deep discount. The distinction is that high-quality equities appreciate over time.
Entrepreneurial success Warren Buffett, the CEO of Berkshire Hathaway, is a big believer in value investing, which seeks out inexpensive stocks with the potential for long-term growth. Buffett acquired this method from Benjamin Graham, his professor – the same Benjamin Graham who wrote The Intelligent Investor.
How Undervalued Stocks Appear
Stocks become undervalued for a variety of reasons, including the following:
Market changes: market crashes or corrections may result in a decline in stock prices.
Unexpected negative news: stocks might become undervalued due to negative press or economic, political, and societal upheavals.
Cyclical volatility: specific industries' stocks perform poorly during certain quarters, affecting share prices.
When stocks do not perform as projected, the cost can plummet.
Tips for Trading Undervalued Stocks
Trading undervalued stocks may appear to be a sure thing – after all, the term "undervalued" suggests that the price will eventually climb. However, there are a few critical points to remember when evaluating these stocks.
Value is a subjective concept
To begin, keep in mind that value is subjective, and there is no single method or statistic that can be used to assess a stock's "real" value. Indeed, there are numerous valuation models available, and they frequently produce inconsistent findings. As a result, it is often impossible to determine with certainty whether a stock is undervalued.
Additionally, some sorts of values are difficult to quantify numerically. Even if you believe, for example, that a stock is undervalued due to changing consumer habits, determining what those changing consumer habits entail for the company's income might be challenging.
Stocks Can Remain Undervalued for an Extended Period
Additionally, keep in mind that just because a stock is undervalued does not guarantee that its price will immediately increase. Indeed, undervalued stocks can remain undervalued for months or even years - as long as the market takes its time appreciating a company's potential.
As a result, value investors must exercise patience. This kind of investing is often more suitable for long-term investors than for traders seeking to quickly enter and exit a stock.
Cheap Does Not Mean Undervalued
Additionally, it is cheap to note that a stock trading at a discount to its historical average price is not always undervalued. The market price of a stock can fall in response to weak earnings or a dimming outlook, and the new, lower price represents a fair value.
When looking for stocks that are trading at a discount, it is critical to do an in-depth analysis of why the inventory is changing so cheaply in the first place.
10 Ways to Find Undervalued Stocks
These ten methods will tell you how to find undervalued stocks:
Price-to-earnings ratio (P/E)
The P/E ratio is the most often used metric for determining a company's value. In essence, it indicates how much money you'd have to spend to earn $1. A low price-to-earnings ratio may indicate that the stocks are undervalued. The P/E percentage is derived by dividing the share price by the share earnings (EPS). EPS is determined by dividing the entire profit of the business by the total number of shares issued.
Example of a P/E ratio: You purchase ABC shares at $50 per share. ABC has ten million shares in circulation and earns $100 million in profit. This equates to a $10 EPS ($100 million/10 million) and a 5 P/E ratio ($50/$10). As a result, you'll need to invest $5 for every $1 earned.
Debt-equity ratio (D/E)
The D/E ratio compares a business's debt to its assets. A larger ratio may indicate that the company obtains the majority of its capital through lending rather than from shareholders – but this does not always suggest that the stock is undervalued. A company's D/E ratio should always be compared to the industry average. That is because a 'good' or 'poor' balance is industry-specific. Divide liabilities by stockholder equity to arrive at the D/E ratio.
Example of a D/E ratio: ABC has $1 billion in debt (liabilities) and $500 million in stockholder equity. The D/E would be a factor of two ($1 billion/$500 million). This indicates that for every $1 of equity, there is $2 of debt.
Return on equity (ROE)
ROE is a ratio that quantifies a business's profitability in relation to its equity. Divide net income by shareholder equity to arrive at the ROE. A high ROE may indicate that the shares are undervalued, as the company generates a lot of revenue in comparison to the amount invested by shareholders.
ABC has a net income of $90 million (income minus liabilities) and stockholder equity of $500 million. As a result, the ROE is 18% ($90 million/$500 million).
Earnings yield
Earnings yield can be thought of as the inverse of the P/E ratio. Instead of price per share divided by earnings, it is earnings per share divided by cost. According to some traders, a stock is undervalued if its earnings yield is more than the average interest rate paid by the US government when borrowing money (known as the treasury yield).
Example of earnings yield: ABC has earnings per share of $10 and a share price of $50. Earnings yield will equal 20% ($10/$50).
Dividend yield
The dividend yield is a word that refers to the ratio of an organization's annual dividends – the part of profit distributed to stockholders – to its share price. Divide the yearly premium by the current share price to obtain the percentage. Traders and investors prefer companies that provide a consistent dividend yield, as this indicates more excellent stability and earnings.
ABC distributes annual dividends of $5 per share. The current share price is $50, implying a 10% dividend yield ($5/$50).
Current ratio
The current ratio of a business indicates its ability to repay loans. It is determined by dividing total assets by total liabilities. A current ratio of less than one indicates that penalties cannot be adequately met by available assets. The lower the current balance, the more likely the stock price will continue to decline - maybe to the point of being undervalued.
ABC has $1.2 billion in assets and $1 billion in liabilities (debt), so the current ratio is 1.2 ($1.2 billion/$1 billion).
Price-earnings to growth ratio (PEG)
The PEG ratio compares the P/E ratio to the annual EPS growth rate in percentage terms. If a company has solid earnings and a low PEG ratio, its stock may be undervalued. Divide the P/E ratio by the annual EPS growth rate to obtain the PEG ratio.
ABC's P/E ratio is 5 (price per share divided by earnings per share), and its annual earnings growth rate is 20%. The PEG ratio would be 0.25 (5/20%).
Price-to-book ratio (P/B)
The P/B ratio is used to compare the current market price to the book value of a company (assets minus liabilities, divided by the number of shares issued). Divide the market price per share by the book value per share to arrive at this figure. If the P/B ratio is less than one, the stock may be undervalued.
Example of a P/B ratio: ABC's shares are selling for $50 each, but its book value is $70, implying a P/B ratio of 0.71 ($50/$70).
Low Market-to-Book Ratio
This is calculated by dividing the total market capitalization of the company's stock by the shareholder equity. If this value is low, it may imply that the stock price is low in relation to the company's net worth.
This is a ratio that warrants extreme caution. While a company's book value was historically a significant measure of worth, it will become less so in the future. This is especially true now when most enterprises are involved in service or intellectual property businesses, both of which have very minimal asset bases. Additionally, analysts and investors are typically more interested in revenue and profit growth than in the company's book value.
However, a low market-to-book ratio is a positive sign of an undervalued stock since it indicates that the company's assets are valuable in comparison to the market value of its stock. In exceptional circumstances, the net worth of a company's assets may exceed the market value of its stock.
While this typically implies a company is in trouble, it can also mean an undervalued stock scenario. A competitor may be willing to pay more than the current stock price for the company's assets. If you purchase the stock before a competitor acquires it, you may profit from the transaction immediately.
Using Fundamental Analysis
Fundamental analysis is the process of determining a stock's target price through the use of financial measurements and comparisons. If the target price is greater than the current market price, you've discovered an undervalued stock. Professional and advanced investors frequently employ a variety of strategies. The following are some of the most critical fundamental analysis ratios and methods used in stock valuation:
Discounted Cash Flow Analysis: A discounted cash flow (DCF) analysis is a process that entails forecasting a company's future cash flows and using those predictions to ascertain the company's current worth.
Dividend Discount Model: The dividend discount model calculates a stock's intrinsic value by analyzing a company's current and projected dividend payments.
Most Undervalued Stocks for 2022
Undervalued company stock is one that is consistently profitable and has good long-term growth prospects but trades at a discount to many of its rivals. These stocks can be excellent buy-and-hold investments for patient investors prepared to wait for hidden deals.
1. Berkshire Hathaway
When it comes to the best-undervalued stocks, Warren Buffett's Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) deserves to be at the top of the list. Buffett amassed one of the world's greatest fortunes through decades of successful acquisition and holding of high-quality firms. Although Berkshire Hathaway underperformed the S&P 500 (SNPINDEX: GSPC) in the 2010s (and again in 2020, when the market favored high-growth technology companies), that dynamic shifted dramatically in 2021 and 2022, as value stocks made a comeback.
Berkshire Hathaway is a holding firm that includes insurance companies (including GEICO), the country's largest railroad, energy, and utility conglomerate (including a sizable renewable energy branch), and a variety of other businesses ranging from food to clothes. Berkshire Hathaway also owns substantial investments in Apple (NASDAQ: AAPL), Bank of America (NYSE: BAC), and Coca-Cola (NYSE: KO) (NYSE: KO).
2. Target
Target (NYSE: TGT) is a Dividend Aristocrat, having grown its dividend to shareholders annually for nearly 50 years. Following a banner year in 2020, when the COVID-19 pandemic began, the corporation increased revenue in 2021. Target, best known as a big-box retailer, has evolved into a one-stop-shop for everything from groceries to essential household items. Additionally, Target operates its own in-house labels in typical department store categories such as clothes and home goods.
The company's actual distinction is that practically every resident of the United States lives within a 10-mile radius of a Target store. This has aided the company in converting its stores into distribution facilities. Indeed, about 95% of all orders – including many placed online and shipped directly to customers' homes – are completed by local retailers, not distribution centers. Target offers curbside pickup and is extending its Shipt delivery service in addition to delivering a pure e-commerce experience.
Target aims to boost yearly capital expenditures to around $4 billion in the future years, including building new shops, remodeling existing locations, and improving supply chains – a significant increase from the approximately $2.7 billion allocated annually from 2016 to 2020. The company is committed to growing its e-commerce operations while maintaining a consistent dividend payout.
However, the company's stock continues to trade as if it were a traditional brick-and-mortar retailer. Target is pursuing a multifaceted strategy that maximizes the value of its physical footprint. The popularity of pure-play e-commerce companies also adds to Target's stock being undervalued.
3. The Amazon
Amazon (NASDAQ: AMZN) put an end to years of speculation about whether its huge enterprise could ever earn a profit. It has been rapidly and consistently increasing its net income rates year after year. However, Amazon may not be the first business that comes to mind when considering an undervalued company. After all, this is still a growth stock.
Amazon is capitalizing on the early epidemic boom it had in the spring of 2020 when everyone was confined to their homes and shopped virtually entirely online. And it is doing so while maintaining a double-digit percentage growth rate and producing record profits. The majority of its profit is reinvested to stimulate further growth.
4. JPMorgan Chase & Co
JPMorgan Chase (NYSE: JPM) is a global financial services and investment banking conglomerate that manages more than $3 trillion in assets. It is a banking behemoth with a negligible footprint in many American cities. The bank has a global presence and is rapidly growing its reach, particularly in emerging nations where financial services are not readily available to most people. JPMorgan has a strong presence in China.
JPMorgan also has a slew of other levers to accelerate growth. Its bank branches can assist it in increasing deposits and credit card issuance, offering complex services such as wealth management, and deepening its relationship with clients. Banking services geared at local communities to promote diversity have also been incorporated into the new steady expansion strategy.
JPMorgan's shares move similarly to other traditional banks, even though the corporation competes in the technological industry. While pure-play fintech businesses command significantly higher premiums, this huge bank will continue to outperform as people increasingly handle their accounts via mobile devices.
5. IBM
IBM (NYSE: IBM) is a renowned name in the technology industry. It began more than a century ago and has undergone numerous transformations to adapt to the shifting competitive landscape. IBM has suffered over the last decade as cloud computing has become the standard, but the corporation is about to embark on a new chapter in order to focus squarely on this megatrend.
IBM divided a sizable piece of its existing company (namely, its managed infrastructure segment) into a stand-alone corporation called Kyndryl at the end of 2021. (NYSE: KD). What remains is a smaller IBM that focuses on the hybrid cloud market and provides a range of services from data center building to software development.
The new IBM serves a fast developing industry that comprises public and private data centers as well as cloud computing service providers. According to IBM, the advent of cloud technology has created a global business potential of approximately $1 trillion each year.
Bottom Line
It would be reassuring to believe that undervalued stocks will eventually beat the market. However, this is not always the case. While new firms are regularly added to analysts' buy lists, there is no certainty that a stock you own or are contemplating purchasing will ever appear on one of those lists.
When it comes to investing, you can generally expect present patterns to persist until market dynamics undergo a significant shift that disrupts the established order.
However, if this occurs, particularly during a prolonged bad market, undervalued stocks may suddenly garner significantly more attention from analysts, portfolio managers, and individual investors. It's a sector worth monitoring, even if you have no immediate investment plans.
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