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How to Find Undervalued Stocks

If you are looking for undervalued stocks in the stock market, then you must be a bargain hunter. But unlike being in a typical market, haggling won’t work with undervalued stocks because these are time-limited offers unknown to almost everyone. In the stock market, you need an investing strategy used by intelligent investors like Warren Buffett—the value investing strategy.

Just the Nuggets

  • Value investing is a strategy introduced by the Father of Value Investing himself, Benjamin Graham. Its foundation is based on knowing the difference between price and value.
  • Price is what everyone sees. Value is the real worth of the company’s stock based on their financial reports (e.g. income reports and balance sheets).
  • When the share price is below the intrinsic value, the stock is undervalued. This happens when the company receives bad press, experiences low revenues, or when the hype is directed to a downward trend.
  • In order to find undervalued stocks, you must understand the business, use valuation metrics and stock screeners, and know the intrinsic value of a company’s stock.
  • Valuation metrics like the P/E, PEG, and P/B ratios are your indicators for undervalued stocks. Paired with stock screeners, you can filter out your search to narrow down your choices.
  • The Graham Formula is a good starting point for investors to know the rough estimate of a stock’s intrinsic value.

The Intelligent Investor’s Strategy

Benjamin Graham, more aptly referred to as the Father of Value Investing, introduced this strategy in his book The Intelligent Investor. He emphasized that intelligent investors understand the difference between price and value.

Price vs. Value

Price and value may both have the same unit of currency but they do not tell you the same thing. Price is easy—it’s the amount you’re paying or receiving when you buy or sell a stock. The stock market displays prices for everyone to see.

Value, on the other hand, is quite tricky. You have to look at the numbers from a different angle where only a few could see from. If the price is greater than the intrinsic value, the stock is overvalued. If the price is less than the intrinsic value, the stock is undervalued.

The Shopping Analogy

Value investing is comparable to buying that coveted Nike Air Max shoes at a discount. 

Suppose you passed by a Nike store and decided to do some window shopping. You picked up the Nike Air Max shoes you’ve been eyeing for quite some time now. But they’re at a regular price. You closed your eyes and summoned the resistance to give in to temptation. “I’ll wait for the sale season,” you told yourself before reluctantly leaving.

That happened a few months ago. Now, to your delight, the shoes are still there and sold at a 40% discounted price! So you finally bought them, and you just feel good about yourself.

The key takeaway here is—buying undervalued stocks means getting more than what they’re worth by paying less. This is the reason why investors should not look at the market price alone when making investment decisions. The true gems are the undervalued stocks—stocks that are sold at prices below their intrinsic value.

A Closer Look into Undervalued Stocks

Price deviates from intrinsic value simply because the market, by its nature, is erratic. By now, maybe you already understand why the market price fluctuates. Going deeper past the Law of Supply and Demand, the main driving forces are greed and fear. 

Here are some instances when prices go way below their intrinsic values because of emotional investing.

  • When a company gets bad press, more people would let go of their shares and sell them. 
  • During the off-season of seasonal businesses, revenues reported may not meet the investors’ expectations. As a result, more people will sell their shares to cut losses.
  • When natural disasters or health crises happen, the market crashes and incites fear of bankruptcy. Again, to prevent losses, people sell their shares.
  • The stock market is one big social group. Wherever the hype goes, people hightail towards it. Even without fully understanding why people start selling, they follow the trend. People are vigilant towards each other’s actions in the hopes of riding the wave as soon as it builds up. 

If you’ll notice, the common denominator is when sellers dominate the market; thus, supply increases. Following the Law of Supply, the price will fall. Instead of speculating, this is the opportune time for investors to find undervalued stocks. Remember the shopping analogy? Discounted prices are up for grabs!

However, the trend will not always dive down. If history taught us anything, what comes down will eventually bounce back up. The market will naturally correct itself such that the price and value would balance out. This is when sale prices go back to their regular prices.

Long-term investors will benefit from undervalued stocks through capital gains—profit you earn from selling a stock at a price higher than when you bought it. This is why value investing has been pointed out to be the most rewarding strategy by prominent investors like Warren Buffett and Peter Lynch. 

Now, the next question is…

How to Find Undervalued Stocks?

1. Understand the business

Familiarize the business models of your top picks. If you take a look at their financial reports and understand how they process everything to gain revenues, you will have the upper hand. When you see the trend start to dip, you won’t be easily swayed by the hype because you understand how the business and the market works. You know how the company will approach the occasional lows in the market. 

2. Get to know the valuation indicators

Unlike prices, intrinsic values are not plainly visible to everyone. You’ll have to dig deep using investing tools and measuring instruments to see the value. But first, it’s important to know the fundamentals of knowing how to pick your stocks before attempting to find if they are undervalued. Once you’re familiar with the quantitative fundamentals and what they signify, you can use financial ratios as your market indicators. These will be your measuring instruments to see if you’re close to finding the undervalued stocks. 

Here are the basic indicators that you should look out for:

1. Price-to-Earnings (P/E) Ratio

Significance: This tells you how expensive the stock is relative to the company’s earnings per year. This is usually labeled as P/E (TTM) where TTM means trailing twelve months

Rule of Comparison: The lower the P/E, the better.

where Earnings Growth Rate = [(Current Year Earnings – Previous Year Earnings) / Previous Year Earnings] * 100
2. Price-to-Earnings Growth (PEG) Ratio

Significance: When PEG~1, it’s a positive signal that the company’s earnings are growing quickly at a fairly affordable price. 

Rule of Comparison: The lower the PEG, the better.

where (1) Market Value per Share = the price at which the market currently values the share, and (2) Book Value per Share =the price per share in case of liquidation, after all assets are sold and all liabilities are paid.
3. Price-to-Book (P/B) Ratio

Significance: If the P/B < 1, then it’s a signal that the stock is undervalued since the market share price is lesser than the net worth value per share. 

Rule of Comparison: The lower the P/B, the better.

These valuation metrics should not be treated as standalone yardsticks. Despite the rules of thumb, these financial ratios depend heavily on the industry. Thus, they are most effective when comparing values between competing companies in the same industry.

3. Use stock screeners

The stock market is a big, dynamic place. Can you imagine going through the list of US stock companies to see which of them are qualified for the rules of thumb of the valuation metrics? That would be painstaking, exhaustive work. Luckily, there are stock screeners to address this problem.

Stock screeners are investing tools that help you filter the stocks based on what you’re looking for. You can narrow down the list to show stocks with PEG ratios below 1 only, and even further to a particular type of industry, say, the financials group. These are only two of the vast filters you could use. Some examples of stock screeners are Gurufocus and Yahoo! Finance.

Gurufocus

This is the all-in-one screener that you will see on their website.

The first filter you’re going to set will be the region of the stock market. As you can see, the US stock market alone has 31,326 available results. 

Next, you can choose what type of filters you would want to use. Since you’re looking for the financial ratios, you can select the Valuation Ratio tab. Then, you can set the range of values that you’re looking for. Note that it’s best to know the ideal values per industry as your benchmark. But for simplicity, you can use general rules of thumb like P/E < 15, PEG < 1, and P/B < 1. 

After you’ve set the values, you can see the results as shown above. There’s a column for the current price and basic valuation metrics. From 31,326, you have narrowed down the search results to just 155! However, the companies are blurred out unless you are subscribed to Gurufocus’ website.

Yahoo! Finance

You can use this stock screener for free. When you open their site, hover over the Screener tab then choose Equity Screener so you can see the stocks.

Just like Gurufocus, the first filter is the region of the stock market. But this one’s more specific because the choices are by country. Then, you can filter the stock by their degree of market capitalization if you want to view blue chips only, or price if you want to set the value according to your budget, industry, and sector. These are the default filters. However, you can click the Add another filter button to add some valuation measures.

Suppose you are finding large-to-mega-cap stocks in the financial sector, specifically in the insurance industry, that is below your $100 budget. When you apply the rules of thumb in the filters, you’re down to five results. You can then view each result to look for more information, like financial reports and company-related business news.

4. Compute for the intrinsic value

The valuation metrics are simply your indicators, while the stock screeners are your filter tools. Both of them are your signals that the stocks may be undervalued. But the fact is, you still don’t know the intrinsic value.

Here’s a little bit of math. But don’t worry, all you have to do is find the valuation metrics with the help of stock screeners, and then Trade Brains’ Graham Calculator will do the rest for you. 

The formula above from Benjamin Graham will give you a simplified approach to determining the rough estimate of a stock’s intrinsic value. Once you have it, compare it with the current share price. If price < intrinsic value, then the stock is undervalued.

How to Use the Graham Calculator?

For illustration, you can use Amazon as our sample stock.

  1. Using Yahoo! Finance, enter the stock symbol AMZN in the search bar. What you’ll see on your screen is somewhat the same as the picture shown above. The current price is $3,421.30 and the EPS (TTM) is 26.04. By the way, you can see in the green box that Yahoo! Finance directly displays the fair value or the intrinsic value. Unfortunately, this is only available for their premium members.
  1. You can find the growth rate (g) when you click the Analysis tab. Scroll down to the bottom until you reach the Growth Estimates section. The value for g is 36.03.
  1. Gather the value of Y from Moody’s Seasoned AAA Corporate Bond Yield. Take the most recent data. In this case, Y is 2.31 for August 24, 2020.
  1. Lastly, when you’ve gathered all the data, you can directly input them into the calculator to determine the intrinsic value.

The intrinsic value is $3,995.8 per share. Compared to the current price, the intrinsic value is greater. This means that the stock is undervalued when the current price is $3421.30.

Again, this is just a rough estimate. Take note that the Graham Formula was introduced in the 1970s. A lot has changed since then. There are more sophisticated intrinsic value formulas available. But for beginners, the simplified Graham Formula is a good starting point.

Closing Notes

Finding undervalued stocks is a numbers game. As an intelligent investor, you must decide by the figures and not by market sentiment.

“The stock investor is neither right nor wrong because others agreed or disagreed with him. He is right because his facts and analysis are right.” – Benjamin Graham

Our References and Further Readings

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