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How to identify undervalued stocks

With the invention and mainstream adoption of the internet, investing — which was once available to a small elite with enough money and valuable contacts — became available to everyone in the world. Of course, most of it is now done online, and you can do it from the comfort of your home, simply by making an account with a broker and giving it instructions on what to do with your money.

So, access to stocks and stock investing is not a problem anymore. However, finding the right stock to invest in is.

You see, with the internet, you have access to the entire world — countless markets are just waiting for you to come to them and invest. Of course, you can play it safe and invest in some massive companies, such as Microsoft, Apple, or any other huge brand out there.

But, the fact is that you probably won't be able to invest much, as their stocks are extremely valuable and expensive. A far better alternative is for investors to find cheap stocks with great potential. These are known as undervalued stocks, and today, we are going to explain exactly what they are, why they might be undervalued, and how you can recognize them and seize profitable opportunities before the prices start surging up.

So, let's start from the beginning and explain the basics.

What are undervalued stocks?

As the name suggests, undervalued stocks are stocks whose value is below the level at which it should be. These usually refer to rather successful emerging companies whose stocks should be more expensive, but for some reason — they are not.

You see, there is a concept called 'fair' value, and it is reserved for the value of stocks that corresponds with the success of the company. If a firm is successful, its stocks' price is high. If it suffers an incident of some sort, loses its popularity, ends up involved in legal matters, or something like that — the stock value usually falls, as it is in correlation with the firm's reputation.

Basically, you could say that the stock's 'fair' value is its real value. Any stocks whose 'fair' value is higher than their value in the market are considered undervalued.

In other words, if you can identify which stocks are actually worth more than the price under which they are offered, you can invest int them and wait for the price to catch up to the 'fair' value, and make a profit along the way.

Why are stocks becoming undervalued?

There are plenty of reasons why a stock would become undervalued. Perhaps the company in question is not as popular or lacks exposure, but it does pretty good work and sees great growth.

Such firms can even see growth in sales and profits as they travel from one quarter into another, but their stock prices simply end up behind, as the firms go unnoticed by investors and traders.

Alternatively, perhaps the firm saw some negative press, which causes the traders to lose faith in it and oversell its stocks. In that case, the stock price would drop due to greater supply and lower demand. However, the negative press might not damage the company enough for it to go out of business.

If that happens, you end up with a still quite successful firm and an extremely cheap stocks belonging to it.

Sometimes, it is just a good old market crash that takes its stocks down, and they take a bit of time to get back up. In any event, the result is the same — a good company ends up with cheap stocks that you can buy and profit when the price eventually catches up.

The key here is that you cannot just find cheap stocks and assume that it's just undervalued. You need to ensure that the stocks — and the company itself — is of good quality and that it has potential.

Sometimes, a cheap stock is just a cheap stock, and its fair value is equal to its presented value. This usually happens to firms of lesser quality, shady practices, and alike.

The undervalued stocks will always catch up to its real value, and that just takes time. Bad stocks will never grow to become more valuable than the price they already have — at least not unless the company does a lot of work in order to better itself.

So, how do you do it? How do you identify undervalued stocks?

Well, if your guess is that you need to do tons of research, then you are correct. However, the first step of that research is to learn what to look for, and that is what you are going to learn right now.

How to identify undervalued stocks?

There are two things that traders do to find undervalued stocks, or simply try to predict the price movement of stocks before investing in them. This is done regardless of the type of stock — it might be a successful one or an undervalued one, the research methods are the same.

We are, of course, talking about using fundamental and technical analysis.

Technical analysis is basically a way to determine the stock's value and potential by examining its historical data. That means looking at charts and statistics that show how the stock performed throughout the company's history.

Charts and stats are valuable information, as they can show you at which part of the year you can expect the stock to rise, and when it might see a correction. For example, if a company sees a lot of sales during the winter holidays, then investing in it near the year's end is the best way to make some profit.

If the same stock tends to drop after the holidays, since the sales drop during that time, then that is something that you should take as an indicator of when to sell.

On the other hand, we have fundamental analysis, which is a method of evaluating the value of assets through the study of external influences and events, industry trends, financial statements, and alike.

Using the same example, the fact that the winter holidays are approaching means that the company will likely see greater sales and that its stock will rise.

Basically, fundamental analysis shows you the reason why the firm's stock might rise, while technical analysis is there to confirm it and show how the firm performed in the past. How much did the price go up, as well as how much did it drop during the correction that follows.

This example shows how traders can use both methods together, in combination, in order to find undervalued stocks.

Now, another thing that you should be aware of is that there are several primary ratios that form part of the fundamental analysis that you need to consider, alongside using the technical analysis. These rations can and will vary based on the industry or sector in which the company you are looking to invest in operates. However, you can still use them to your advantage.

1) P/E ratio

The first on the list is the so-called P/E ratio or Price-to-earnings ratio. This is the most popular way to measure the value of the firm and the stock and see if the value corresponds to fair value.

Basically, this ratio shows how much you have to spend in order to make a $1 profit. The first thing that you need to calculate is the firm's earnings per share, which you can do by finding the firm's total profit and then dividing it by the number of issued shares.

You then calculate the ratio by dividing the price of the share by the earnings of the share and see what you end up with. If the ratio is low, then the stocks are undervalued, and it pays to invest.

2) P/B ratio

Next up, we have the P/B ratio, or Price-to-Book ratio. This is a ratio that allows you to assess the current market price against the firm's book value. It is a pretty simple calculation that you can make by dividing the market price per share by the book value per share. If you end up with the result that is below one, then the stock is most likely undervalued.

3) Dividend yield

In the third spot, we have a method called the dividend yield, and it is basically a term that is used for describing the firm's yearly dividends compared to the stock price.

What you do here is divide the annual dividend by the price of a single share. The greater the percentage you end up with, the more stable the firm, and the more substantial the profits will be.

4) ROE

ROE, or Return On Equity, is another way to measure the firm's profitability, only this time, it is against its equity. The calculation is rather simple here, as well, and you need to divide the net income by shareholder equity. If the percentage is high, that means that the firm is generating a strong, high income as opposed to the amount of investment by shareholders. Therefore, the shares are undervalued, and you should consider investing in them.

5) D/E ratio

Next, we have a D/E or Debt-Equity ratio. Once again, we rely on equity, only this time, this ratio will measure the firm's debt against its assets.

If the ratio is high, that means that the firm is getting its funding from lenders instead of shareholders. However, it is important to note that this does not necessarily mean that the stock is undervalued. Because of that, you need to make sure that it is by measuring the D/E ratio against the average of the firm's competitors.

This is where the sector or the industry in which the firm operates comes into play, and you cannot compare firms from different industries and receive trustworthy results.

6) Earnings yield

Another way to measure whether or not the stock is undervalued is through earnings yield, which uses a similar method as the P/E ratio, only in reverse. What this means is that you need to divide earnings per share by the price, instead of the other way around.

This time, you need the earnings yield to be higher than the average interest rate that the government tends to pay when it borrows money, in order to be able to consider stocks undervalued.

7) Current ratio

Another way to assess if the stock's price is undervalued is the firm's current ratio. Essentially, this is represented through the firm's ability to pay off its debts. It is yet another simple calculation where all you need to do is divide the assets by liabilities. If the ratio is lower than one, this usually indicates that the firm cannot cover its debts with assets that it has at its disposal. The lower the ratio goes, the bigger the chance that the price will keep sinking.

However, if the sinking continues, the price could maybe then become undervalued at some point.

8) PEG ratio

Lastly, we have PEG, or Price-Earnings to Growth ratio. This one compares the P/E ratio and compares it to the percentage of growth in the company's annual earnings per single share. If a PEG ratio is low and the firm has solid earnings, the stock is probably undervalued.

Conclusion

Investing in undervalued shares is a great way to earn a sizable amount of money in the long run, and all you really need to do is find which stock is undervalued. Making a proper assessment is the key to seeing profits, rather than losses, so use as many methods to check the company's track record as possible.

With proper research and a few ratio calculations, you can make a pretty decent assessment, so you don't have to invest blindly and hope for the best. Instead, use the proven methods, and be smart about it, so that you don't lose your money by relying on simple luck.

Any questions? You can call us on 09 281 2012 or email us at info@rockfortmarkets.com any time to help you with your trading requirements.
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