How to find undervalued stocks

What are undervalued stocks?

An undervalued stock is one with a price that is lower than its real – ‘fair’ – value. Stocks can be undervalued for many reasons, including the recognisability of the company, negative press and market crashes. A key assumption of fundamental analysis is that market prices will correct over time to reflect an asset’s ‘fair’ value, creating opportunities for profit.

Finding undervalued stocks isn’t just about finding cheap stocks. The key is to look for quality stocks at prices under their fair values, rather than useless stocks at a very low price. The difference is that good quality stocks will rise in value over the long term. Many traders and investors like to mimic Warren Buffett’s strategy, which has always been about finding undervalued stocks and those with the potential to grow over the long term.

Remember, you should always gather the right financial information about a stock you’re looking to trade and not make decisions based on personal opinions alone.

Why do stocks become undervalued?

Stocks become undervalued for different reasons, including:

• Changes to the market: market crashes or corrections could cause stock prices to drop
• Sudden bad news: stocks can become undervalued due to negative press, or economic, political and social changes
• Cyclical fluctuations: some industries’ stocks perform poorly over certain quarters, which affects share prices
• Misjudged results: when stocks don’t perform as predicted, the price can take a fall

How do traders find undervalued stocks?

To find undervalued stocks, traders use fundamental and technical analysis. Fundamental analysis is a method of evaluating the value of an asset by studying external events and influences, as well as financial statements and industry trends. Technical analysis is a means of examining and predicting price movements using historical charts and statistics.

Generally, traders should use both methods, together, to find undervalued stocks, as this will give the most complete picture of the market. There are a few primary ratios that form part of fundamental analysis that traders should consider, in conjunction with technical analysis.

Eight ways to find undervalued stocks

As part of fundamental analysis, there are eight ratios commonly used by traders and investors. The following ratios could be used to find undervalued stocks and determine their true value:

1. Price-to-earnings ratio (P/E)
2. Debt-equity ratio (D/E)
3. Return on equity (ROE)
4. Earnings yield
5. Dividend yield
6. Current ratio
7. Price-earnings to growth ratio (PEG)
8. Price-to-book ratio (P/B)

In the section below, we look at each of these ratios in detail. Keep in mind that a ‘good’ ratio will vary by industry or sector, as they all have different competitive pressures.

Price-to-earnings ratio (P/E)

A company’s P/E ratio is the most popular way to measure its value. In essence, it shows how much you’d have to spend to make $1 in profit. A low P/E ratio could mean the stocks are undervalued. A P/E ratio is calculated by dividing the price per share by the earnings per share. The earnings per share are calculated by dividing the total company profit by the number of shares they’ve issued.

P/E ratio example: You buy ABC shares at $50 per share, and ABC has 10 million shares in circulation and turns a profit of $100 million. This means the earnings per share is $10 ($100 million/10 million) and the P/E ratio equals 5 ($50/$10). Therefore, you’ll have to invest $5 for every $1 in profit.

Debt-equity ratio (D/E)

The D/E ration measures a company’s debt against its assets. A higher ratio could mean that the company gets most of its funding from lending, not from its shareholders – however, that doesn’t necessarily mean that its stock is undervalued. To establish this, a company’s D/E ratio should always be measured against the average for its competitors. That’s because a ‘good’ or ‘bad’ ratio depends on the industry. D/E ratio is calculated by dividing liabilities by stockholder equity.

D/E ratio example: ABC has $1 billion in debt (liabilities) and a stockholder equity of $500 million. The D/E ratio would be 2 ($1 billion/$500 million). This means there is $2 of debt for every $1 of equity.

Return on equity (ROE)

ROE is a percentage that measures a company’s profitability against its equity. ROE is calculated by dividing net income by shareholder equity. A high ROE could mean that the shares are undervalued, because the company is generating a lot of income relative to the amount of shareholder investment.

ROE: ABC has a net income (income minus liabilities) of $90 million and stockholder equity of $500 million. Therefore, the ROE is equal to 18% ($90 million/$500 million).

Earnings yield

The earnings yield can be seen as the P/E ratio in reverse. Instead of it being price per share divided by earnings, it is earnings per share divided by the price. Some traders consider stock to be undervalued if the earnings yield is higher than the average interest rate the US government pays when borrowing money (known as the treasury yield).

Earnings yield example: ABC has earnings per share of $10 and the share price is $50. The earnings yield will be equal to 20% ($10/$50).

Dividend yield

Dividend yield is a term used to describe a company’s annual dividends – the portion of profit paid out to stockholders – compared to its share price. To calculate the percentage, you divide the annual dividend by the current share price. Traders and investors like companies with solid dividend yields, because it could mean more stability and substantial profits.

Dividend yield example: ABC pays out dividends of $5 per share every year. The current share price is $50, which means the dividend yield is 10% ($5/$50).

Current ratio

A company’s current ratio is a measure of its ability to pay off debts. It is calculated by simply dividing assets by liabilities. A current ratio lower than one normally means liabilities can’t be adequately covered by the available assets. The lower the current ratio, the higher the likelihood that the stock price will continue to drop – even to the point of it becoming undervalued.

Current ratio example: ABC has $1.2 billion in assets and $1 billion in liabilities (debt), so the current ratio equals 1.2 ($1.2 billion/$1 billion)

Price-earnings to growth ratio (PEG)

PEG ratio looks at the P/E ratio compared to the percentage growth in annual earnings per share. If a company has solid earnings and a low PEG ratio, it could mean that its stock is undervalued. To calculate the PEG ratio, divide the P/E ratio by the percentage growth in annual earnings per share.

PEG ratio example: 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 equal to 0.25 (5/20%).

Price-to-book ratio (P/B)

P/B ratio is used to assess the current market price against the company’s book value (assets minus liabilities, divided by number of shares issued). To calculate it, divide the market price per share by the book value per share. A stock could be undervalued if the P/B ratio is lower than one.

P/B ratio example: ABC’s shares are selling for $50 a share, and its book value is $70, which means the P/B ratio is 0.67 ($50/$70)

How to trade undervalued stocks

To trade undervalued stocks, start by going through the eight ratios outlined above. The main aim is to find shares with ratios different to the industry norms. Remember, while these ratios are useful, they should only form part of your fundamental analysis. This, in turn, should be combined with thorough technical analysis for a full view of the market.

To learn more about fundamental and technical analysis, visit IG Academy.

Once you’ve identified the stocks you want to trade, you can trade on their prices via a CFD trading account. If you choose to trade the stocks, you could open a position when the ratios have deviated from industry norms and close your position when they have returned to the industry standard.