Investing > How To Find Undervalued Stocks

How To Find Undervalued Stocks

Undervalued stocks are out there—all you have to do is find them.

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Updated February 17, 2021

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What does the life of a successful trader look like to you?

Some dream of hitting the jackpot, retiring on a serene, sunny beach, and drinking mimosas for days on end. 🏖

Sounds like the life, right? Well, before that orange juice-flavored hangover kicks in, we need to dive into some numbers.

Average stock market returns have sat around 10% per year since the 1920s. With returns like that, it’s going to take most people a few decades to save up enough money to retire to the beach. For investors looking for a payday now, it’s going to take research, market knowledge, and commitment to finding the stocks that can beat average returns.

We’ve gathered some of the best techniques out there to help you find the right stocks to build a value-oriented portfolio. These techniques will help you sift through the overvalued, inflated, and garbage stocks, and uncover those hidden gems that you can ride to large returns.

So – are you ready? Let’s get to it! 🚀

What you’ll learn
  • Why Do Stocks Become Undervalued?
  • Where to Find Undervalued Stocks
  • How to Find Undervalued Stocks
  • Undervalued Stocks vs. Value Traps
  • Finding Undervalued Penny Stocks
  • Additional Strategies
  • Tips to Keep in Mind
  • Get Started with a Stock Broker

Why Do Stocks Become Undervalued? 📉

Stocks become undervalued for many different reasons. Although some of the best investors try to keep a cool head, it’s undeniable that the market is driven by two emotions: fear and greed. These are constants for old pros and people just learning to trade stocks. People want to make as much money as possible, and they don’t want to be left holding the bag when trades turn sour.

With that in mind, stocks often become undervalued when the market is volatile. When there are market crashes, valuation is going to fall below normal. When there is a lot of excitement around earnings or major company news, we see valuation jump.

This is one of the reasons oil companies crashed in the early days of the pandemic. Investors were terrified of market conditions and large oil companies hit valuations that were not reflective of their underlying assets.

Not only are companies going to become undervalued from world events and earnings news, but there are also cyclical fluctuations in the market. Some companies are going to outperform others during different stages of the economy—this may be what is happening with casino stocks.

Oftentimes, when a company is seeing a sell-off due to news or market conditions, traders will overcorrect. This means that the true price of the stock should be different than what investors are trading at. They push the asset outside of the normal, sustainable threshold—and here is the opportunity for savvy traders.

Where to Look for Undervalued Stocks 🔎

So, you want us to tell you what stocks are criminally low? You want to get on the next Tesla or Amazon or Netflix before it blows up?

Well, let us tell you the secret: You need to do your own research. 🤷‍♂️

Undervalued stocks aren’t going to be the stocks that are shared around to the masses. In fact, if most people are buying the same stocks, that is going to lead to average returns, because the average investor is trading the asset. To make above-average returns, you have to break away from the pack.

To start researching stocks you will need to learn how to evaluate companies and learn about financial metrics. You will have to determine the health of the company, the competency of the institution’s management, and how much money a company makes.

All of these things have a major impact on the long-term health and stability of a corporation. When looking for value stocks, you need to evaluate your trading strategy. Are you investing for the long haul? Or do you want to get in and out with your cash as fast as possible? This is important to consider in whatever trading you are doing, even if you are just learning about buying stocks.

To find stocks, use a financial information website to browse and filter companies. You can use tools like Google Finance or Yahoo Finance to compile information. Some stock browsing sites will have complex filters where you can view only stocks that meet your criteria.

Above all of that though, you will need to find a company that hasn’t already shot sky high with Price to Earning ratios of 40-80% and beyond (looking at you TSLA 😑). Let’s look at some of the metrics we can use to determine if a stock is undervalued.

How to Determine if a Stock is Undervalued

Using the stock browser and tools available from some of the top stock brokers, you are going to narrow down the major market indexes to a few choice stocks to consider investing in. But how do you narrow those companies down? You look at the numbers.

PE Ratio ⚖️

PE Ratio, or price-to-earnings ratio, is one of the most common valuation numbers. It is useful because it compares the profitability with the share price of a company. However, the PE ratio is often considered backward-looking or a historical metric because it does not attempt to predict future profitability.

One way that price-to-earnings ratios are so useful is that it lets you compare companies that have different outstanding shares. Let’s look at AAPL and AMZN as examples.

StockShares OutstandingMarket PriceMarket Cap
APPL16,790,000,000$135.37$2.27 trillion
AMZN500,890,000$3,277.71$1.64 trillion

While APPL has 16.79 billion shares outstanding, AMZN only has 500.89 million. How do you know how expensive those respective shares are in relation to the other company? 

By just looking at the stock and market valuation of the company, you can start to see how Amazon’s fewer but more expensive shares relate to Apple’s greater number but less expensive shares. It isn’t very straightforward to see; however, if we use the PE ratio it is easier to compare the two corporations dollar for dollar.

AAPL and AMZN Historical PE Ratios 👇

YearAPPL EPSAMZN EPSAAPL PriceAMZN PriceAAPL PE RatioAMZN PE Ratio
2015$2.36$1.25$24.34$675.8910.31540.71
2016$2.10$4.90$27.38$749.8713.05153.03
2017$2.44$6.15$40.65$1,169.4716.69190.16
2018$3.05$20.14$38.46$1,501.9712.6074.58
2019$3.18$23.01$72.67$1,847.8422.8980.31
2020$3.71$34.15$132.49$3,148.7335.7192.20

Looking at historical earnings and stock price for AMZN and APPL gives us a better understanding of how the PE ratio is calculated. Generally, higher earnings push the stock price up, as well as the PE ratio.

Although AAPL seems like a better option at first glance because if it’s lower PE ratio, the ratio is becoming bigger and bigger year after year. On the other hand, Amazon’s PE ratio is rapidly decreasing—so which one is a safer investment?

Earnings Per Share (EPS) 🔒

Here’s how this works. For every earnings per share (EPS) that APPL makes, investors are willing to pay 36.72 times that amount to hold the company. For the past 12 months, Apple has made approximately $3.69 per share for 16.79 billion shares, and investors are buying shares at around $135.

On the other hand, Amazon investors are paying 78.36 times their earnings to hold the company. We see that Amazon investors are paying more per share. We can compare the two even though they are totally different companies with totally different books.

APPLAMZN
PE Trailing Twelve Months36.7278.36
EPS Trailing Twelve Months3.6941.83

To find a value company with PE ratios, you want to find a stock that is going to see its earnings meet its price. For many value investors, that means finding stocks that have PE ratios of 15 or less.

Finding a lower PE ratio company means that investors are paying less of a premium to hold the stock. This also reduces the risk of buying a company because there is a higher chance that the stock will meet earnings expectations.

PE is Not the Wonder Metric ⚠️

While the PE Ratio is helpful in determining whether a stock is expensive or not, it doesn’t tell the whole story. The ratio may not reflect insider knowledge, a company can have a low ratio because there is a problem with the corporation, or perhaps it’s managed poorly or has lots of debt.

Another problem with relying too heavily on PE ratios is that it can eliminate good investments because it does not account for intrinsic value. Intrinsic value is a more accurate value of a company that the market does not represent.

Tesla Investors may be intimately familiar with this. TSLA currently has a PE ratio close to 1,300. Investors are paying 1300 times the earnings that each share makes for the privilege of holding the company.

P/E Growth (PEG) 💡

The Price/Earnings-to-Growth ratio is a powerful way to find undervalued stocks and it expands on the PE ratio. The PEG ratio works by dividing the price by the earnings per share and then dividing that number by Predicted Earning Per share growth.

PEG Ratio

If the PEG number is below 1 then investors are relying heavily on past performance to justify share price. If the number is greater than 1, investors are expecting the profitability of the company to rise over time.

Relying on estimated PE Ratios and growth rates, Amazon’s PEG Ratio right now is 2.47. We can tell from this number that investors are expecting to see an increase in Amazon’s profitability.

PEG fills in more of the picture because instead of looking backward, you are keeping target prices in mind. To find an undervalued stock you need to look for companies that are going to continue to be profitable.

The average PEG ratio is going to look over a growth period of 5 years. It is especially useful when you are evaluating stocks that have a high PE ratio now, but that ratio may be justified given rapid growth.

Dividend Yield Percent 💸

Dividend yield percent is another easy way to narrow down your search for undervalued companies. It is not always essential to find a dividend-paying stock, but one study has shown that dividends can increase the stability of stock price.

Like all of our other financial metrics, not one thing is going to make or break the stock. When you combine the metrics, they will help you understand the larger story.

Dividend yield may be a good indicator because it can help you understand the health of a company. If a stock has a strong dividend (greater than 1%)—or its dividend is better than its peers, and the payment is sustainable—you may have a company that is strong, profitable, and is using its money wisely.

Be warned, some companies will raise their dividends just for the sake of attracting new investors. This can inflate the price of a stock when the underlying company is trash. You can avoid companies that do this by looking for dividend payers that have had steady payments and increases over a long period of time.

You want to see a company have a dividend that grows. This helps investors realize short-term gains. But if a company’s dividend is much greater than the S&P 500’s average, you may need to research other financials of the company to understand if it’s stable.

Price to Book Value Ratio 💰📒

The price to book (or market to book) value is another one of those terms that come up often whenever we look at stocks. The price means the market capitalization of a company: what all the outstanding shares are worth—you can find this number by multiplying the stock price by the number of outstanding shares.

The book value is what a company is worth when its assets are sold and its debts are repaid.

PB Ratio

The price to book value is essential in understanding how much cash flow a company has access to. If all of the company’s revenue is tied up in repaying debts, then they aren’t going to be able to grow.

When looking for potentially undervalued companies, you want the price to book ratio to be less than one to find an undervalued stock. Less than one means a stock is at a price lower than the assets are worth.

Higher than one means that a company is performing well and investors expect the returns to continue to increase. This often means the stock price is higher.

Cash Per Share Ratio 🗂

The cash per share ratio is something that goes hand in hand with the price to book ratio. This ratio will look at how much cash a company has access to in the short term. This money can be for things like R&D and other fees associated with doing business.

Cash per Share greatly contributes to the overall health of a company. If a company is able to liquidate assets quickly to adapt to market changes, it will be better equipped when the waters get choppy.

If you are long on a company, you want them to be secure in both the short-term and the long-term. Cash per share is how we look at the short-term.

Cash per share can also be a bad thing. It can mean that a company isn’t optimizing its profits. If you are looking at an undervalued company that is holding on to too much cash, it may mean they are forfeiting returns.

Other Metrics 📊

The list of metrics will go on and on. Here are some other important metrics to stay on top of:

Current RatioDebt-to-EquityReturn on Equity (ROE)
A company’s assets divided by liabilities. Useful for seeing access to cash in the short-term.Divide the debt of a company by shareholder’s equity. Useful for seeing how much a company relies on debt to grow.A company’s net income divided by shareholder’s equity. This shows how well investments generate profits.

Value Stock Screening ✅

All the metrics in the world aren’t going to help you unless you have stocks to screen. Fortunately, many of the top brokers like Fidelity Investments already offer extensive tools to help investors.

Something to keep in mind when evaluating stocks is that it isn’t always about the metrics. You want to look for companies with good management. Even really wonderful companies can be destroyed by the wrong people running them.

You want to find companies that are making the right decisions with the competition. Things like patents and trademarks help prevent excessive competition from cutting into profits.

You should also ask yourself if you understand the company you’re putting your money in. How do they make a profit? Do they own lots of things (factories, trademarks, etc.)? Either way, a good stock screener will make this part of the job much easier—don’t worry, most of the top stock trading apps nowadays have top-notch research and screening capabilities.

Undervalued Stocks vs. Value Traps ⚠️

Sometimes you may find stocks that you think the market is sleeping on, but instead, they are just duds. The low value is justified and could be attributed to any number of things like poor management, new corporate laws, or some news event you are not aware of.

One way to avoid value traps is by staying away from stocks that don’t show any signs of life. If you are evaluating a stock and it is trading near its 52-week low with not much volatility, this is probably a sign of a value trap. Short-term investors don’t have the momentum they need to make any money on price changes.

Other value traps are companies that have shot up due to heavy speculation but don’t have much of a future. We saw this kind of valuation happen shortly after the COVID-19 shutdown with stocks like Wayfair. Recently we’ve seen stocks such as GameStop and AMC spike due to a short squeeze, which doesn’t indicate that these companies will do great in the future.

These companies may not have much going for them in the long-term. Compare stock performance with its price, and try to avoid excessively high PE ratios.

Finding Undervalued Penny Stocks 🥇

Finding good undervalued companies doesn’t just extend to major corporations. Investors should also keep an eye out for cheaper assets.

Using some of the top penny stock brokers can help get you the resources for loading up on an undervalued company. You are going to apply the same research and market knowledge that you do to large companies.

Some sites may even offer recommendations on undervalued stocks to buy, but be sure you investigate the stock yourself. After all, it is your money on the line, not theirs. Keep in mind that companies are often cheap for a reason, so don’t buy too much penny stock without extensive research.

A Strategy for Finding Undervalued Stocks 💭

A common strategy for finding undervalued stocks is to start with a large selection of potential stocks that meet your qualifications. Remember, when investors analyze stocks they look for things like low PE ratios, good EPS estimates, maybe a steady dividend, and many other things. You will narrow down the entire stock market into those stocks that are good trades and then continue to cut down the list.

It’s important to understand the stock market and be aware there aren’t a ton of undervalued stocks out there. If the market was so largely undervalued, we would probably be in the middle of a crash. If you aren’t in a crash and lots of companies are getting through your filters, try being more discriminating.

After you’ve narrowed down a list based on financial metrics, research other parts of the business. Ask yourself these questions:

  • How does the company make money?
  • Do I think this company’s profits will grow or stay the same?
  • Is the management competent and responsible?
  • Why is this stock undervalued?
  • How long will I hold this stock?

Once you’ve narrowed down your list, done your research, and figured out your investing plan—the next step would be actually investing.

7 Tips Before You Start Investing in Undervalued Stocks

Before you start investing your hard-earned money in undervalued stocks, consider a few more aspects of buying undervalued stocks. You don’t want to lose out on money for no reason.

  1. Be aware that it can take a long time for stock prices to appreciate. The stock you pick needs to mesh with your investing strategy.
  2. Look for stocks that are already profitable and that their cash flow is increasing. If a company is becoming more profitable but their cash flow is not increasing, there may be problems with the asset.
  3. Have high standards when looking for undervalued stocks. Just because the share price is low does not mean the company is undervalued.
  4. Look for good barriers to entry for competitors. Things like patents, trademarks, and economies of scale help a company stay profitable in a crowded industry.
  5. Research the executives running a company. It’s good to stay away from scandalous CEOs and people known for fraud.
  6. Buy companies where the stock price is lower than the intrinsic value. If you are entering at a price lower than the worth of all the corporation’s assets, you are limiting your risk.
  7. Look for companies with a market capitalization under $1 billion. This is a good way to avoid larger investors.

How COVID-19 Has Impacted the Stock Market

The COVID-19 pandemic rocked the stock market back in early march of 2020. We saw some extreme sways that led to many companies becoming undervalued… This was a great proof of concept that some companies are going to drop to prices that are not representative of the stock.

The important take-away was that these extreme shifts do happen, one might be happening right now. If you are able to stay calm and not let fear take control, the opportunity to gain a lot of money is there. On another note, long-term investors may be at an advantage during crashes as we’ve seen with bitcoin investors keeping their eyes on the horizon.

When crashes come, the market changes. Companies you used to understand are going to be harder to interpret. Famous investor Warren Buffet sold his airline shares for billions of dollars of loss because he did not understand how the company would continue to operate under the conditions of the pandemic.

While that number may be sickening, let’s understand that investors need to stick to their strategy. Warren Buffet, a famous value finder, is one of the most successful investors of all time for a reason—he never puts hasty solutions before long-term goals.

Finding Undervalued Stocks: FAQs

  • What are the Benefits of Undervalued Stocks?

    The benefit of buying an undervalued stock is that you have the potential for above-average gains. You can not beat the market if you are buying the same companies as the rest of the market.

  • Why Do Companies Split Their Stock?

    Companies split their stock to make the trading price more reasonable to investors. For example, Tesla split its stock because a single share cost hundreds of dollars—this would have limited the number of investors who can buy the company due to financial restraints.

  • What are Value Stocks?

    Value stocks are assets that have a low stock price compared to their metrics. These are often companies that are very profitable but have not yet been recognized by investors as such.

  • How Old Do You Have to Be to Invest in Stocks?

    You have to be 18 years old to invest in stocks without a custodial account. This applies to all states in the U.S.

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