Here’s how to find undervalued stock picks — and maximize your long-term profits.
One of the key principles of successful investing is to buy high-quality “value stocks”: They’re undervalued stock picks; i.e., they are reasonably priced, if not cheap, in relation to their sales, earnings and assets. Typically, value stocks trade at prices lower than their financial fundamentals would suggest.
As more investors come to recognize the value of so-called undervalued stock picks, they begin to rise. Well-informed investors who recognized the value when the stock price was lower then benefit from the rise.
When you start investing, you may see the secret to investment profit as “buy low, sell high.” But that’s hard to do consistently. You’ll often buy just before prices fall, or sell just before they rise. If you stick to high-quality value stock picks, however, your short-term gains and losses can average out but you’ll still profit greatly in the long run. Here are 10 factors to look for when judging an undervalued stock pick for its investment quality.
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Financial factors to look for in undervalued stock picks:
5 to 10 year history of profit. Companies that make money regularly are safer than chronic or even occasional money losers.
5 to 10 years of dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
Manageable debt. When bad times hit, debt-heavy companies often go broke first.
Safety factors for undervalued stock picks:
Industry prominence if not dominance. Major companies can influence legislation, industry trends and other business factors to suit themselves. Minor firms, on the other hand, have to take what’s there.
Geographical diversification. Canada-wide is good, multinational better. There’s extra risk in firms confined to one geographical area.
Freedom to serve (all) shareholders. High-quality value stock picks must be free of excess regulation, free of dependence on a single customer, and free from self-dealing insiders or parent companies.
Survival/growth factors for undervalued stock picks:
Freedom from business cycles. Demand periodically dries up in “cyclical” businesses, such as resources and manufacturing. That’s why you need to diversify. Invest in utility, finance and consumer stocks, along with cyclical resource firms and manufacturers.
Ability to profit from secular trends. For undervalued stock picks, among others, these trends outlast ordinary business booms and busts, because they reflect ongoing social change. Free trade and rising environmentalism are just two examples of secular trends.
Ownership of strong brand names and an impeccable reputation. Customers keep coming back to these businesses, and will try their new products.
Spinoffs are often undervalued stocks in disguise. Companies often do spinoffs when they feel it isn’t a good time to sell. Instead, they choose to hand out shares of the new firm to their shareholders. That often results in buying opportunities in undervalued stocks.
Four financial ratios we use to uncover bargain stocks and undervalued stock picks
When you’re looking for undervalued stock picks, as a first step it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele.
High-quality undervalued stock picks like these are rare and hard to find, even when the markets are down. But when you know what to look for, you can discover them. These are four of the financial ratios we use as a guide to spotting undervalued stock picks:
1. Price-earnings ratios: The p/e is the ratio of a stock’s market price to its per-share earnings. As a general rule, the lower the p/e, the better, and generally a p/e of less than 10 represents excellent value.
To determine undervalued stock picks, we calculate the p/e ratio for a stock by using the most recent financial data. But we also analyze the “quality” of the earnings. For instance, we disregard a low p/e ratio if it is due to a one-time capital gain on the sale of assets, since the gain temporarily bloats the “e.” (That shrinks the p/e.) Similarly, we add back any one-time earnings writeoffs, so we don’t miss out on bargain stocks that would have had low p/e ratios if not for one-time writeoffs.
You need to remember that a low p/e can be a danger signal. A low share price in relation to earnings may mean earnings are falling or about to fall. That’s why it’s crucial to view p/e ratios in context. Instead, we check to see if other financial ratios confirm or contradict their value.
2. Price-to-book-value ratios: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share gives you a rough idea of the stock’s asset value. This ratio represents a “snapshot” of an instant in time, and could change the next day. Asset values on a company’s books are the historical value of the assets when they were originally purchased, minus depreciation. (Certain types of assets on a balance sheet might have actual market values well above historical values, as sometimes happens with real estate or patents.)
When we find a stock with a low price-to-book value, we look to see if the price is too low, or if its book value per share is inflated. Often, we find that the stock price is too low. But, sometimes, the company’s assets are overpriced on the balance sheet, and at risk of being written down.
3. Debt to equity ratios: This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity. In essence, you assume an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of its capital.
4. Price-cash flow ratios: Cash flow is actually a better measure of a company’s performance than earnings. While reported earnings are subject to accounting interpretation and can be restated in later years, cash flow is a measure of the cash flowing into a company less cash outlays.
Simply put, it’s earnings without taking into account non-cash charges such as depreciation, depletion and the write-off of intangible assets over time. Cash flow is particularly useful in valuing companies in industries in which depreciation and depletion charges are based on the historical value of assets instead of current values—industries such as oil and gas, and real estate. As with any financial ratio, you always have to look at it in context in order to find truly undervalued stock picks.
Do you have your own set of criteria for spotting undervalued stock picks? Share your experience in the comments.
This article was originally published in 2016 and is regularly updated.
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