According to value investors, undervalued stocks can be found under any market conditions. These investors believe that the stock market is not always efficient at pricing stocks and that fundamentally sound stocks trade at an undervalued price at any given time. In the long run, it is believed the market for these securities will correct, sending the stock price up to its appropriate value and earning the savvy value investor a significant profit in the process.
It is not uncommon for a company to show earnings and income growth for several years with strong demand for its goods and services while being largely ignored by Wall Street.
Undervalued stocks, then, are stocks that are selling at significant discounts to their intrinsic values- that is, the net present value of the stock, given the expected growth rate of the company. The difficulty, of course, is in determining what the “true” value of the stock actually is.
A rule of thumb for value investors is to look for an excellent stock at a good price rather than a dirt-cheap stock of a company with weak fundamentals and growth expectations. The stock of an excellent company is far more likely to return to favor and bounce back.
Using a Stock Screener to Find Undervalued Stocks
A stock screener is a very useful tool for finding undervalued stocks. Some of the criteria to filter for include:
Low P/E (Price/Earnings) Ratio
This very important valuation ratio of a company’s current share price compared to its earnings per share. This measure is most useful when compared with other companies within its industry. The P/E ratio indicates how much you are willing to pay for each dollar of earnings. By definition, then, with a low P/E ratio, you are getting these earnings for less.
Low PEG (Price/Earnings to Growth) Ratio
The PEG ratio compares the stock’s P/E ratio to the expected annual earnings per share (EPS) growth. It is believes that a fairly-priced stock will have a PEG ratio of 1. It follows then that an undervalued stock will have a PEG ratio of less than one. Very good value is generally believed to be at a PEG ratio of .5 or less.
Low Debt to Equity Ratio
This ratio is used to measure a company’s financial leverage. A high debt/equity ratio can signal that a company is over-leveraged, possibly financing its growth through the acquisition of debt. The resulting additional interest expense can create a real burden for the company.
High Net Profit Margin
A high net profit margin indicates that the company has control of its costs, an indication of strong management. Like the P/E ratio, it is best to compare profit margins within industries.
Low Trading Volume
The idea here is that stocks with high trading volumes are on the radar of institutional investors, making them less likely to remain undervalued.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.