How To Find Undervalued Stocks – Checklist
- PE Ratio: Find companies with lower PE Ratio than competitors with similar growth prospects
- Low Institutional Ownership: Companies that Wall Street has not discovered yet
- High Insider Ownership: Firms management with a vested interest in success
- Revenue: Look for solid revenue growth compared to competitors
- Cost of Revenue: Lower cost of revenue compared to the competition
- Operating Income or Loss: Look for positive operating income
- Net Income or Net Loss: Do not buy an unprofitable company
- Free Cash Flow: Cashflow is King – ensure the company has plenty left over after operations expenses are covered
- Financing Cash Flow: If this is high it might mean financiers see it as high risk
- Cash and Equivalents: The more cash in the bank the better.
Introduction To Finding Undervalued Stocks
The dream of every stock picker is to find undervalued and unappreciated equity that will turn into the next Amazon (NASDAQ: AMZN).
Astonishingly, Amazon’s share price went from $1.50 in May 1997 to $1,847.51 on May 14, 2019. In fact, Amazon shares have gone as high as $2,039.51, Macrotrends.net reports.
Moreover, $100 of Amazon shares bought at the company’s 1997 initial public offering (IPO) was worth $120,762 on August 31, 2018. Thus, Amazon share price grew by 120,000% in less than 20 years.
However, did the market undervalue Amazon for most of its history? Not really, Amazon always traded with a very high price-earnings ratio (PE Ratio). Incredibly, Amazon was trading at $93.36, under $100, in September 2009. Notably, Amazon’s stock price did not rise over $100 until October 2009.
Why are Stocks are 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.
In addition, 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.
The Green Lumber Fallacy Explains Why Stocks can be Undervalued
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.
Mr. Market is Insane and that’s Good
Interestingly, there is a large school of investors who operate on the premise that the market never accurately prices stocks.
This popular name for this school of thought is value investing, and it was most famously articulated by the great American investor Benjamin Graham in the 20th Century. Specifically, Graham taught that Mr. Market was insane.
To explain, Graham described the market as an insane salesman, called Mr. Market. Thus a good way to think of the market is a crazed car salesman.
For instance, one day Mr. Market will try to sell you a Ferrari for $100. However, the next, Mr. Market will offer you a 20-year-old Chevy that does not run for $10,000.
Graham’s basic teaching was that the market is insane and rarely prices any company accurately. Graham’s most famous pupil; Berkshire Hathaway’s (NYSE: BRK.B) Warren Buffett, shares this belief. Most observers regard Buffett as the world’s most successful value investor.
How to Find Undervalued Stocks with Hidden Value
Consequently, 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. To clarify, 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.
What Investors don’t know can Make you Money
Thus, value investors try to guess what other investors do not know about companies or their businesses.
Thus, a tech value investor will look for a company that makes a widely used; but under-appreciated, component or software. For example, most tech investors ignore NVIDIA (NASDAQ: NVDA); which makes the graphics cards video games operate on.
[Related Article: Is NVIDIA The Best Tech Stock?]
A related method is to watch the investment media and look for news that is wrong or incomplete. For example, news stories about one problem at a company, or news focusing only on a stock’s price.
How Warren Buffett Makes Money from Bad News
In fact, investors like Buffett look for companies generating bad news. To clarify, Buffett looks to see if those companies are making money, and sometimes buys them.
In particular, one of Buffett’s most famous investments is American Express (NYSE: AXP). To explain, in 1963, American Express made a big loan to a company called Allied Crude Vegetable Oil which manufactured salad oil.
However, the media reported that Allied Crude’s management faked the inventory of vegetable; or salad, oils American Express based the loan on. Consequently, America Express’s share price fell.
However, Buffett examined American Express’s credit card business found it to be good and bought more of the stock. Consequently, the share price went up; and Buffett made money, after investors forgot the “Salad Oil Scandal.”
Mr. Market often overprices stocks because the media paints an inaccurate picture of a company’s business. Specifically, the Allied Crude loan was a small part of American Express’s business. However, reporters exaggerated its effect on American Express.
How to Make Money from Unpopular Stocks
A popular variation of Graham; and Buffett’s value investing, strategy is to search for unpopular stocks that have a lot of unappreciated value.
Buffett views the stock market as a popularity contest that reflects the opinions of investors, speculators, and traders, rather than reality. Thus, many stocks have high prices because market players like them.
Therefore, Buffett looks for valuable stocks that Mr. Market does not like. For instance, companies that are not sexy or fashionable but still make money.
Using Financial Reports to Find Undervalued Stocks
An example of such a company is the giant American discounter Walmart (NYSE: WMT). Unlike Amazon, Walmart is not popular and traders often ignore it. However, Walmart will pay a dividend of 53₵ on September 3, 2019.
In addition, Walmart’s share price grew from $84.39 on May 14, 2018 to $100.52 a year later. Walmart is under-appreciated because many investors falsely regard it as a dying company. In addition, richer investors are not likely to shop at Walmart, so they are unaware of the company’s size and capabilities, and the money it makes.
In fact, Walmart is still the world’s largest retailer. Moreover, Walmart reported annual revenues of $514.405 billion and a gross profit of $129.104 billion on January 31, 2019.
Therefore, it pays for investors to spend more time reading financial reports than watching CNBC. Famously, Buffett admits he often ignores the financial media.
Where to Look for Undervalued Stocks
Hence, many value investors like Buffett spend most of their time reading financial reports and information. Specifically, many value investors spend a lot of time at websites that provide detailed financial information.
Examples of such sites include Bloomberg, and Yahoo! Finance. However, sites like Ycharts charge for detailed financial information. On the other hand, you can find a lot of free detailed financial information at places like Stockrow and Yahoo! Finance.
Importantly, these websites describe financial numbers that can show you how much money a company actually makes. Therefore, reading financial reports is a good way to find undervalued stocks.
Information that can Help you Find Undervalued Stocks
Financial numbers that can help you identify undervalued stocks include:
- Revenue: This number is all the money a company takes in from all sources. Generally, analysts regard revenue as the best description of a company’s size, or the potential of its business. Note journalists often misreport revenue as “sales.”
- Cost of Revenue: This number reflects the amount of money the company had to spend to generate that revenue.
- Operating Income or Loss: This figure tells you how much company made or lost on its operations. If you see a negative number like this; -$1.157 billion after the words operating income it means a company is losing money on its operations.
- Net Income or Net Loss: If this number is positive it tells you how much the company made after covering its operating costs. If this number is negative, it tells you how much money the company lost after covering its operating costs.
- Operating Cash Flow: This number tells you how much cash the company ran through its operations.
- Free Cash Flow: This number is important because it tells you how cash the company had left over after covering all of its costs.
- Financing Cash Flow: This figure tells you much money the company makes in the financial markets. It can also tell you much money the company loses or makes by servicing loans and debts.
- Cash and Equivalents: This number tells you much cash the company has in the bank.
- Short-term Investments: This number shows much money the company has invested in bonds or equities like Treasury Notes management can sell fast for cash.
- Cash and Short-Term Investments: This figure reflects the amount of cash a company’s management can lay its hands on quickly.
Attributes of an Undervalued Stock
Notably, many value investors look for companies with low share prices that have lots of cash flow, revenue, or cash.
For instance, Apple (NASDAQ: AAPL); which Buffett recently bought, had $42.304 billion in cash and short-term investments on March 30, 2019. Thus, many people now consider Apple a value investment.
[Related Article: Why Warren Buffet Loves Apple]
Accordingly, Apple had a quarterly free cash flow of $8.792 billion and an operating cash of $11.348 billion on the same day. In addition, Apple reported quarterly revenues of $58.015 billion and a gross profit of $21.821 billion.
However, many observers consider Apple undervalued; because its shares traded at $189.18 on May 14, 2019. Moreover, some investors consider Apple undervalued because its share price was around 10% of Amazon’s in May 2019.
Thus, being undervalued is as much a result of an investor’s opinion as anything else. For example, some investors consider low-priced stocks that pay a good dividend as undervalued.
Meanwhile, many growth investors will ignore dividends completely. Instead, they will concentrate on a stock’s rate of growth, or potential for growth.
Undervalued Dividend Stocks
Notably, Apple will pay a dividend of 77₵ on May 16, 2019 while Amazon famously pays no dividend. In addition, there are many cheap stocks that pay dividends.
For instance, the Ford Motor Company (NYSE: F) was trading at $10.25 a share on May 14, 2019. Yet, Ford will pay a 15₵ on June 3, 2019. Thus all Ford shareholders should receive 15₵ a share regardless of the share price.
Hence, many investors compare the dividend to the share price. In particular, many dividend investors will choose a stock that steadily pays a high dividend over one with no dividend and a growing stock price.
In addition, some investors will examine dividend statistics like the dividend ratio, annualized payout, and payout ratio before buying a stock. To explain, the dividend yield is how of much a share the dividend is worth.
Meanwhile, the annualized payout is the total dividend amount a shareholder will receive every year. Finally, the payout ratio is the percentage of a company’s income paid out in dividends.
Therefore, many regard Apple as a good dividend stock because it had a dividend yield of 1.66%, an annualized payout of $3.08 and a payout ratio of 26.2% on May 14, 2019.
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 its risks.