How to Find Undervalued Stocks in 3 Steps - No BS Investing
Posted 310 views August 19, 2022, 10:00 - Elisabeth in Investing

How to Find Undervalued Stocks in 3 Steps

Finding undervalued stocks is the backbone of value investing. You’re looking for high-quality companies selling at bargain prices (hint: the market doesn’t know these companies are undervalued). Your goal is to outperform the market by buying and selling these stocks over the long term. 

But how do you identify truly undervalued stocks rather than following the masses? Below, we dive into the definition of these types of stocks and three steps on how to find undervalued stocks.

Key Takeaways:

  • Step 1: Research and shortlist potential stocks by looking at high dividend yield, low price-to-book ratio, and low price-to-earnings. 
  • Step 2: Calculate more financial ratios (e.g., earnings per share) and review qualitative factors such as company management. 
  • Step 3: Analyze the intrinsic value of each company and compare it with the stock’s price to determine if it’s undervalued. 
how to find undervalued stocks

What are undervalued stocks?

An undervalued stock is a stock that is selling at a stock price significantly below its intrinsic value (i.e., what something is worth based on its intrinsic features). According to Warren Buffett, “Price is what you pay. Value is what you get.” This sentiment perfectly sums up undervalued stocks. 

Maybe a stock is selling for $25, but it’s actually worth $50 based on strong fundamentals, such as consistent profitability and long-term growth prospects. Its price shows that the company’s stock is valued below the industry average (the market doesn’t yet recognize its value). It’s an undervalued stock. 

So why aren’t investors scooping these stocks up? Often, investors are following noise in the market. As quality companies decrease in price or the market tumbles, panicked investors get scared and sell stocks. This is the time to invest in high-quality companies. 

As Warren Buffett also says, “Be fearful when others are greedy and be greedy when others are fearful.” Over time, undervalued stocks will increase in price to match their intrinsic value. That’s when you sell and make returns. It’s a long-term game with undervalued stocks. 

Step 1: Research potential value stocks

First, list 15-30 companies you’d be interested in. Once you’ve analyzed some key fundamentals, you’ll shortlist these companies. 

Make sure you select companies that you can easily explain what they do. “Never invest in a business you cannot understand,” says Warren Buffett. Too often, people invest in companies they don’t understand. Consider investors who sank money into mortgage-backed securities during the housing bubble. These investors lost a lot of money by not understanding what they were investing in. 

Unless you have specific, in-depth industry knowledge, steer clear of hot new stocks such as from tech companies that are difficult to comprehend. Instead, research companies in well-known industries. Some easy-to-understand value companies include:

  • Citicorp
  • JPMorgan Chase
  • Bank of America Corporation
  • Berkshire Hathaway
  • Procter & Gamble
  • Johnson & Johnson
  • Target Corporation
  • Chevron Corporation

Though not exactly “sexy,” these companies are more established with predictable cash flows. 

Once you have a list of companies, filter out the garbage (or at least the stocks with less-than-optimal performance). Analyze if each company has the following:

  • high dividend yield
  • low P/B ratio
  • low P/E ratio

Here’s how to determine each one:

HIGH DIVIDEND YIELD

A high dividend yield means that you earn income from stock investments. If you add dividend stocks to your portfolio, you can expect regular income and earn profits without selling stocks. 

Dividends are portions of a company’s profits that are paid to its shareholders. These dividends are paid in cash or as more stock. Dividends must be approved by a company’s board of directors. 

Cash dividends are the most common type. Say that you own 100 shares in a company. If that company pays $0.50 per share in cash dividends per quarter, you’ll receive $50 per quarter or $200 per year in dividends. 

Look for dividend yield information through financial sites like Morningstar. A dividend yield of 2% to 4% would be considered good or at least above average but 4-6% would be even better. Citigroup, for example, has an annual dividend yield of 4.12%.

LOW PRICE-TO-BOOK RATIO

Price-to-book ratio measures a stock’s price against its book value. To calculate P/B, compare the company’s net or book value to its market value: 

Price-to-book = Market capitalization / Book value of equity 

Market capitalization or market cap is the total value of all a company’s shares of stock. To get this number, multiply the price of a stock by its total number of outstanding shares. The book value of equity is how much cash a company would have after its assets were sold and liabilities were paid off with the money.

A low P/B ratio depends on the industry. Look at the industry average to determine if it’s low or high. However, a good P/B value is typically considered to be any value under 1.0, but a stock with a P/B value under 3.0 is still considered good by some value investors. 

Let’s look at this ratio in practice. Say that XYZ Company’s latest closing share price is $25.00. Its outstanding shares equals $100M. Market cap = $250M.

Now say the company has $200 million in assets and $100 million in liabilities. $500M-$400M = $100M. $100M is the company’s book value. $250M / $100M = 2.5. The company has a P/B value of 2.5x. This means that the market price is valued at over twice its book value. 

LOW PRICE-TO-EARNINGS RATIO

The price-to-earnings (P/E) ratio measures the market price of a stock compared to company profits or earnings. For example, if a company has earnings of $2 per share and its stock is trading at $50, its P/E ratio is 25 ($50 divided by $2).

So let’s say you find a company in a particular industry that has a P/E ratio of 15, but its major competitors are at 25. This can be a basic indicator that the company stock may be undervalued.

Note: Just because a company has a high dividend yield, low P/B, and low P/E doesn’t necessarily mean it’s a good investment. It could be a value trap. However, they are good indicators to start with. 

Step 2: Analyze more data and shortlist your companies 

Once you’ve got your list of 15-30 companies, analyze more quantitative and qualitative factors about each one. Find the company’s financial statements, such as the balance sheet, income statement, and cash flow statements. 

Use a free tool like last10k.com to access these statements. Type in the company’s ticker symbol in the search bar. Look at Item 8 on the company’s 10-K Annual Report for financial statements. From these statements, you can find data to calculate important financial ratios:

  • Working capital ratio
  • Quick ratio
  • Earnings per share (EPS)
  • Debt-to-equity
  • Return on equity (ROE)

Here’s how to calculate each ratio:

WORKING CAPITAL RATIO

Also known as the current ratio, the working capital ratio shows the company’s ability to pay for current liabilities (e.g., rent payments) with its current assets (e.g., cash and cash equivalents). Here’s the formula:

Working Capital Ratio = Current Assets / Current Liabilities

Find current assets and liabilities in the company’s balance sheet. A good working capital ratio is typically between 1.5 and 2. Lower than 1.0 could mean liquidity problems in the future (aka quickly generating enough cash to pay off debt if needed). Compare a company’s working capital ratio with other companies in the same industry. 

QUICK RATIO

Similar to the working capital ratio, the quick ratio measures how well a company’s current assets could cover its current liabilities. 

But instead of looking at all assets like the working capital ratio, this ratio only looks at assets that can be converted to cash within 90 days or less. Here’s the formula:

Quick Ratio = Cash + Cash Equivalents + Current Equivalents + Short-Term Investments / Current Liabilities 

A quick ratio of more than 1.0 is considered less risky than a company with a quick ratio of less than 1.0.

EARNINGS PER SHARE

Earnings per share (EPS) is a calculation that shows how profitable a company is on a per-share basis. 

EPS = Net Profit / Total Number of Shares

A company is more likely to be profitable if it has a higher EPS. Compare the company’s EPS with the industry’s EPS (aka the peers) to determine if it’s good. 

DEBT-TO-EQUITY

Debt-to-equity shows how much debt the company uses to run the business. Running off too much debt or borrowed money means that the company could go under if hard times hit. 

Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity

A good debt-to-equity ratio depends on the industry, but between 1.0-1.5 is preferable. Over 2.0 shows that the company gets two-thirds of its capital financing from debt which can be considered risky. 

RETURN ON EQUITY

The return on equity (ROE) measures the profitability of a company. It shows how effectively a company uses its equity (aka the value of the shares issued by a company). 

ROE = Net Income / Shareholder’s Equity

Although a healthy ROE depends on the company’s industry, an REO above 15% is considered good. However, a healthy ROE can vary depending on the business’s industry.

Hint: Simplify this process. Instead of calculating manually, use a tool like Investing Pro Plus to automatically view key financial ratios. 

Numbers aren’t the only important factors when analyzing companies. Review the following qualitative factors:

BUSINESS MODEL

A company’s business model refers to a company’s plan for making a profit. Understand how the business generates value for its customers. Citigroup, for example, generates revenue by providing various banking products and financial services to individuals, businesses, and government entities.

COMPANY MANAGEMENT

A company might have a stellar product or service, but that doesn’t mean much if the company’s management is poor. 

Review the company’s website, news articles, etc. Check up on the company’s CEO and other executive members to understand if their interests align with their stakeholders and if they make good business decisions. 

For example, value company Berkshire Hathaway’s executive team includes Warren Buffet. His past decisions indicate that company management is strong. 

COMPETITIVE ADVANTAGE 

See how the company’s product or service compares with similar items on the market. Can it sustain its competitive advantage over time? Examples of competitive advantages include:

  • Quality
  • Brand
  • Distribution
  • Network

For example, Johnson & Johnson’s competitive advantages are massive size, scale, and intellectual property library. Select companies whose competitive advantage will still be around twenty years from now. Look at the company’s long-term prospects. 

Use this analysis to make sure you’re investing in good businesses. Narrow down your list of 15-30 companies to 3-5 based on the above factors. 

Step 3: Analyze intrinsic value for each company

Your list of strong companies is now in place. Time to review each company’s intrinsic value and how it compares with the stock price! Intrinsic value is what something is worth based on its intrinsic features.

Value investors look at a company’s intrinsic value because stock prices reflect investors’ perception of reality, not necessarily reality itself. Value investors can take advantage of this. 

Value investors buy when the stock price is lower than the intrinsic value of the company. Over the long-term, the price will eventually equal absolute or intrinsic value, allowing the investor to sell and make a profit. 

There are several ways to calculate intrinsic value. Here are two: the P/E Multiple Model and the DCF Model. Combine results from different methods to get a value range. Focus on conservative estimates. 

P/E MULTIPLE MODEL

Price-to-earnings or P/E multiple is a method that helps you calculate intrinsic value through a five-year price target. It’s a straightforward method that requires three inputs.

Below is the formula for the P/E ratio:

Intrinsic value = Earnings per share (EPS) x P/E ratio x (1 + r)^5 

The three formula inputs include earnings per share (EPS), the P/E ratio, and the expected earnings growth rate (r).

Say that you want to calculate the intrinsic value for Microsoft (MSFT). To find the EPS for Microsoft, head over to a website like Yahoo Finance or Morningstar. Type the ticker symbol into the search bar and look for the EPS under the financial data. 

how to find undervalued stocks eps

EPS shows you the company’s average earnings per share for four quarters. As of the time of writing, Microsoft had an EPS of 8.94.

Now find a reasonable P/E ratio for Microsoft. For this number, visit MorningStar. Insert the ticker symbol and click “Valuation” to find the company’s average five-year P/E ratio:  

price to earnings

Microsoft has an average five-year Price/Earnings ratio of 36.59

Finally, let’s find the expected growth rate. You can calculate this number on your own or visit Yahoo Finance and see what financial analysts have predicted. Click “Analysis” and scroll down to “Growth Estimates.” Look at the “Next 5 Years (per annum):”

Analysts predict that Microsoft will grow at a rate of 16.75% year-over-year over the next five years. But don’t stop here. Build in a margin of safety (just in case this estimation is inaccurate). A conservative margin of safety is 25%. 

Apply this percentage to the 16.75% growth rate. 16.75 * (1 – 0.25) =​ ​12.5625%

We can now put all these inputs together and calculate the five-year price target for Microsoft:

  • Input 1 (EPS): 8.94
  • Input 2 (P/E Ratio): 36.59
  • Input 3 (Expected Growth Rate): 12.56%

Place these inputs in the formula: Earnings per share (EPS) x P/E ratio x (1 + r)^5. We recommend using a scientific calculator: 

8.94 per share x 36.59 x (1 + 0.1256)​^5 = $591.04 per share

Microsoft’s intrinsic value will be $591.04 five years from now. But we need to calculate the intrinsic value today to compare it with the current stock price. This means we need to discount the five-year price target to get the Net Present Value.

Using a 9% discount rate (based on the historical return of the stock market), we’ll divide the original amount by 9%:

591.04 / (1 + 0.09)^5 = $388.04

Since Microsoft’s current stock price is $329.37, the company seems to be slightly undervalued. However, this is a rough estimate. Let’s look at another model to get a better idea if we should purchase Microsoft stock today.

DISCOUNTED CASH FLOW

The discounted cash flow (DCF) model estimates value based on expected future cash flows. It determines the value of a company today by projecting how much money it will create in the future.

Free cash flow (FCF) is this calculation’s most important input. FCF is the amount of money a company can generate, even after expenses. The DCF model looks at the trailing twelve months’ FCF and projects it 10 years from now.

Rather than calculating this valuation by hand, you can use a spreadsheet that does the math for you. Download the DCF valuation spreadsheet from valuespreadsheet.com for free here

[Source]

Simply add the ticker symbol, and the spreadsheet does the rest. Compared to Microsoft’s stock price of $329, notice how the first valuation model suggests that the company is undervalued while the second model suggests Microsoft is overvalued ($384 vs. $173). 

Again, remember that these numbers are just estimates. In this case, we would need to dig more before determining if Microsoft is a safe buy right now. We could use other intrinsic value models like Return on Equity Valuation Model to compare with these results. 

Remember: our goal is to find stocks much less than the company’s intrinsic value. You can’t precisely calculate the value, so be conservative with your estimates! 

Only buy stocks at a massive discount to intrinsic value. This practice gives you a margin of safety and allows you to make money even if your estimate is inaccurate. 

How to find undervalued stocks easily? Use a tool.

As a final step, compare the value of each company with the current stock price. Determine if the price is significantly below your intrinsic value estimation. Then, run your numbers again.

Convinced you’ve found a few high-quality companies at bargain prices? Invest for the long-term! Finding undervalued stocks can be a very time-consuming process. You can use a fundamental analysis tool to simplify the process. We recommend Investing Pro Plus. This tool helps you easily evaluate stock fundamentals. Sign up for a free trial for Investing Pro Plus here.

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Elisabeth O. is an MBA graduate with a specialization in International Finance & Investments and over six years of financial writing experience. She is passionate about long-term investing to build wealth, avoids day trading and speculations, and loves a good Warren Buffet quote.