To find undervalued stocks, you can use established financial ratios such as discounted cash flow, the margin of safety, PEG, price to book, or the price to Graham number. Each ratio provides a unique insight into the company’s value to determine if it is undervalued.
This article will guide you through each ratio and the value investing criteria to help you select the right method to find solid undervalued stocks.
What is an Undervalued Stock?
Undervalued stocks are trading at a significant discount to the value the stock market places on the share price. If a stock price is $10 and a company’s book value is $20 per share, one could estimate that the stock is undervalued by 50%.
Using ratios and calculations like discounted cash flow, future earnings, the margin of safety, and fair value enable you to find undervalued stocks selling at a discount.
Finding Undervalued Companies
To find undervalued companies, you need to estimate what the company is worth. Warren Buffett values a company based on the future cash flow it can generate. Benjamin Graham developed the price to Graham number to value a company. Bruce Greenwald developed Earnings Power Value to value a company.
How to Find Value Stocks
To effectively and efficiently find undervalued stocks, you will need to use a stock screener to sort, filter, and research potential value investments. Many free stock screeners are available online, but only a few are tailored specifically to find value stocks.
|Value Stock Screeners||Stock Rover||Portfolio123||TradingView||Finviz|
|⚡ Financial Metrics||650||240||48||31|
|🏆 Intrinsic Value||✓||✘||✘||✘|
|🎯 Margin of Safety||✓||✘||✘||✘|
|♲ Graham Number||✓||✘||✘||✘|
|📈 PEG Ratio||✓||✓||✓||✓|
|📊 PE Ratio||✓||✓||✓||✓|
|📕 Price to Book||✓||✓||✓||✓|
|🎮 Free Trial||14-Day||21 Days $9||30-Day||30-Day|
Stock Rover is the best screener for value investors because it has the complete complement of value investing calculations built-in, including intrinsic value, fair value, margin of safety, the Graham number, and the Greenblatt and Lynch ratios.
Find undervalued stocks using Intrinsic Value/Fair Value
A professional way to find undervalued stocks is to use the intrinsic value/fair value calculation.
The Intrinsic Value of a stock is an estimate of a stock’s value without regard for the stock market’s valuation. Two popular models are the Dividend Discount Model (DDM) and the Discounted Forward Cashflow (DFC) Model. There are multiple variations of intrinsic value; see our detailed article on intrinsic value.
Warren Buffett bases his Intrinsic Value/Fair Value calculations on future free cash flows. Buffett thinks cash is a company’s most important asset, so he projects how much future cash a business will generate and discounts it against inflation. This is called the Discounted Cashflow Method.
⚡ Undervalued Stock Criteria: Intrinsic Value per Share > Stock Price
Find undervalued stocks using Margin of Safety
Finding undervalued stock using the Margin of Safety is a perfect addition to the intrinsic value calculation. The Magin of Safety is the difference between intrinsic value per share and the actual stock price.
If a stock price is significantly below the actual Fair Value of a company, that percentage difference is known as the Margin of Safety. Essentially the percentage that the stock market undervalues a company.
Buffett’s most important measure to decide whether to invest in a company, the Margin of Safety, is the percentage difference between a company’s Fair Value/Intrinsic Value and its actual stock price. This metric is the most important company valuation metric, as it is the final output of a detailed discounted cash flow analysis.
⚡ Undervalued Stock Criteria: Margin of Safety > 30%
Find undervalued stocks using PEG Ratio
A simple way to find undervalued stocks is by using the Price Earnings to Growth Forward Ratio, or PEG. PEG attempts to improve upon Price/Earnings comparisons by accounting for earnings growth.
PEG is calculated by dividing the forward Price/Earnings Ratio for the next 12 months by the estimated Earnings Per Share (EPS) growth for the next 5 years. The lower the PEG value, the more undervalued a stock is. A PEG value of 1 suggests perfect pricing.
⚡ Undervalued Stock Criteria: Price Earnings Growth < 1
Find undervalued stocks using the Price to Graham Number
You can find undervalued stocks using the price to Graham Number. Created by the king of value investing, the Price to Graham Number is a conservative valuation measure highlighted in his seminal book The Intelligent Investor.
The Graham Number is one of his tests for whether a company is undervalued and is computed as the square root of 22.5 times the tangible book value per share times the diluted continuing earnings per share. A price to Graham Number less than 1 suggests a company is undervalued.
⚡ Undervalued Stock Criteria: Price to Graham Number < 1.0
Find undervalued stocks using Price to Lynch Fair Value
A great way to identify undervalued stocks is using the Price to Lynch Fair Value ratio. Price to Lynch is based on the legendary Peter Lynch’s valuation formula featured in his book One up on Wall Street.
The Price to Lynch Fair Value ratio divides the stock price by the PEG rate times the 5-year EBITDA (earnings before interest, taxes, depreciation, and amortization) growth rate multiplied by continuing earnings per share. A Price to Lynch Fair Value less than 1.0 means the stock is undervalued.
⚡ Undervalued Stock Criteria: Price to Lynch Fair Value < 1.0
Find undervalued stocks using Greenblatt Earnings Yield
Joel Greenblatt’s Earnings Yield calculation allows you to find value stocks by comparing a company’s operating income to its enterprise value. Using the Greeblatt Earning Yield and the Greenblatt Return on Capital calculations is the core of his value investing methodology featured in his “The Little Book that Beats the Market.”
This variation of earnings yield compares Operating Income (Earnings Before Interest & Taxes) to Enterprise Value.
⚡ Undervalued Stock Criteria: Greenblatt Earnings Yield > 3%
Find undervalued stocks using Price to Book Value
Using Price to Book Value identifies undervalued companies, but it does have issues due to what a company includes in Book Value in its accounting practices. Price to book value compares a stock’s market value to the value of total assets less total liabilities.
Book Value is an appraisal of all a company’s assets. A good definition of book value is anything that the company can sell for cash now. Examples of book value assets include real estate, equipment, inventory, accounts receivable, raw materials, investments, cash assets, intellectual property rights, patents, etc. (book value). Also known as P/B or PB, a low P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company.
⚡ Undervalued Stock Criteria: Price to Book Value – Lower is better
Find undervalued stocks using Price to Tangible Book Value
Price to Tangible Book Value is a better way of finding undervalued stocks than the Price to Book calculation. Price to Tangible Book compares a stock’s market value to the value of total assets, less total liabilities, and intangibles.
Removing the intangible assets from the calculation is a way to eliminate companies that may inflate the value of assets such as patents, trademarks, or brands. A low Price to Tangible ratio could mean that the stock is undervalued.
⚡ Undervalued Stock Criteria: Price to Tangible Book Value – Lower is better
Find undervalued stocks using PE Ratio
Although many websites recommend it, the Price Earnings Ratio is a flawed way to identify undervalued companies. The PE Ratio is only useful when comparing competitors in the same industry with similar business models.
The Price-Earnings Ratio (PE Ratio or PER) is a formula for performing a company valuation. It is calculated by dividing the current stock price by the previous 12 months’ earnings per share (EPS). A PE Ratio of 12 means you would pay $12 for every $1 of earnings if you invested.
⚡ Undervalued Stock Criteria: PE Ratio < 4th decile in the industry segment
Finding undervalued stocks with Stock Rover
The most powerful way to find undervalued stocks is to use Stock Rover because its selection of value investing metrics is the best in the industry. Follow these steps to find great value stocks.
- Register for a Free Premium Trial with Stock Rover
- Import the “Buffettology Inspired” Screener or create a new screener with the following criteria:
- Margin of Safety* > 20%
- Fair Value > Than Share Price
- Yearly EPS growth YOY > 5%
- Return on Equity (ROE) 0 > 15%
- 10 Year ROIC Average* => 12%
Full details on this screening technique are here: Value Investing Strategy: 7 Proven Value Stock Screeners.
How to find undervalued stocks on Finviz
Finding undervalued stocks using Finviz is incredibly simple and free, simply visit Finviz and select the following criteria to get a list of value stocks.
- Visit Finviz
- Select the screener tab
- Select the fundamental tab
- Implement the following criteria
- Price/Cash – Low <3
- PEG – Low <1
- P/S – Low <1
- P/B – Low <1
Finding undervalued stocks on TradingView
You can find undervalued stock using TradingView for free. The key criteria are Return on Equity, Price to Book, Price to Free Cashflow, and Return on Invested Capital.
- Visit TradingView
- Select Stock Screener
- Select Financials and enter the following criteria
- Price to Book <5
- Return on Equity >20
- Price to Free Cashflow <5
- Return on Invested Capital >20
Why are stocks undervalued?
Stocks are undervalued because the market is often a poor judge of value. In particular, market players cannot see or appreciate many of the attributes that enable companies to make money. For example, few investors understood the potential value of e-commerce like Jeff Bezos did.
Also, the institutional investors and speculators who drive the market often have a poor understanding of what they are selling. For instance, many investors know little or nothing about the stocks they own, trade, or speculate on.
Finally, most investors and speculators are short-term thinkers. Hence, they fail to grasp the long-term potential of companies like Amazon.
[Related Article: How To Find Value Stocks & Invest Like Warren Buffett]
Why is the stock market bad at stock valuation?
One explanation of why stocks can be undervalued is what investor, philosopher, and former trader Nassim Nicholas Taleb calls the “Green Lumber Fallacy.”
To explain, in his book Antifragile Taleb claims he once knew a commodities trader who made a fortune trading green lumber futures. However, Taleb claims the trader did not realize green lumber is wood or know what they use green lumber for.
Taleb thinks the trader made money because he was lucky enough to invest in the right commodity at the right time. Consequently, the Green Lumber Fallacy is the erroneous belief that traders, speculators, or investors are experts in what they are trading, speculating, or investing in.
Many stocks are undervalued because the participants in the market do not understand them. However, many people believe market participants understand what they are trading. Thus, most people believe the Green Lumber Fallacy and think the market is an accurate pricing mechanism.
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Look for stocks with hidden value
Benjamin Graham advised investors to look for stocks in companies with values the market could not see. For example, a retailer with a low stock price but extensive real estate holdings. The retailer’s business might lose money, but the property its stores sit on could be valuable.
Another example of a low-priced value stock is a company that produces a commodity vital to a growing industry. For instance, a lithium mining company. To explain, lithium is the main ingredient in the batteries laptops, smartphones, and electric cars rely on.
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Are undervalued stocks good?
Undervalued stocks are often good because they are cheap and easier to buy. Therefore, investors can get more bang for their buck by buying more shares.
In addition, undervalued stocks can have less exposure to market fluctuations because people who ignore market fluctuations own them. For instance, shareholders will be less likely to dump Apple during a bear market.
Moreover, undervalued stocks can have unappreciated attributes such as dividends, high cash flow, stability, and growth potential. However, there are risks from undervalued stocks.
Can undervalued stocks be a bad idea?
Undervalued stocks can have serious limitations. For instance, undervalued stocks often have a low share price and limited growth potential. Thus, you will make less money if you sell the shares.
In addition, low-priced stocks can have serious risks. For example, many undervalued companies are vulnerable to disruptive technologies and aggressive competitors. For instance, low-priced retailers like Macy’s (NYSE: M) and Dollar General (NYSE: DG) cannot compete with Amazon because they rely on an expensive and inconvenient traditional business model.
In the final analysis, buying undervalued stocks is a good way to maximize your investments. However, like any other stock, an undervalued stock will have risks.
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