The goal of every value investor is to find stocks that for some reason are undervalued. Maybe the company had a temporary setback and generated less revenue and profit, or there was an economic event, such as a pandemic, that led to less revenue and profit, which led to a tumbling stock price.
How to find undervalued stocks?
You can find potentially undervalued stocks by searching for companies that had a bad performance, a low price-to-earnings ratio, a low price-to-sales ratio, and bottomed out from its 52 weeks low, but also have a low debt to equity ratio, a good return on equity, and substantial estimated growth over the next 5 years.
Read on if you want to learn more about finding undervalued stocks.
The usual value investing process of finding undervalued stocks
When you invest in stocks, using a value investing approach as your strategy, you’ll be usually spending a large amount of time, analyzing sectors with hundreds of companies, to find the real gems that suit your investing style.
During your analysis you’ll find good companies, that you’ll put onto your watchlist, to follow and learn more about them. You’ll also register the stock price of the company and analyze if the company is a good buy.
As a value investor, you will have a certain level of return you expect from companies, but when the economy is doing well, the stock price might be too high to meet your criteria.
You will calculate the intrinsic value of the stock, or in other words, the stock price that you think, would be a good value to purchase the stock to have at least between 10-15% return on equity per year.
You’ll then periodically, or if economic events occur, look at your watchlist, and look if the stock price of the companies has fallen to the level, you considered to buy shares of the company.
If a stock price has reached this threshold, you’ll analyze why the stock price has fallen, and if it was due to a temporary setback, and the chance is high that the price will recover, you’ll purchase the stock.
Using a stock screener to find undervalued stocks
What is a stock screener?
Another approach to find undervalued stocks is by using a stock screener. A stock screener is a tool, with which you can search for stocks that meet certain criteria. The criteria can be a combination of fundamental and/or technical attributes.
Fundamentally you could for example search for all stocks, that have a price-to-earnings ratio under 15.
Technically you could for example search for stocks, where the price just crossed the 20 day moving average.
Which sites offer stock screeners?
FinViz stands for Financial Visualization. FinViz is a company that offers investors different tools with which they can analyze the markets to make their trading decisions.
Yahoo Finance offers financial news, data and commentary including stock quotes, press releases and financial reports.
FinBox is a complete toolbox for investors that has accurate and up-to-date information about publicly traded companies around the world.
What criteria should I use to find undervalued stocks?
What we are looking for are unloved, undervalued stocks, that however have a good return on equity, and a good outlook for growth.
Performance / RoR
To find an undervalued stock, we can use the Rate of Return (RoR). This is a technical attribute, which represents the return over a certain period of time, based on the initial investment.
Let’s say, you bought a stock at $30, and over a year the stock went to $40. The RoR can be calculated as followed:
RoR = (Current Value – Initial Value) / Initial Value * 100(40 – 30) / 30 * 100 = 33.3%
So in this example in this year you had an RoR of 33.3%.
For simplicity in above example, we didn’t include the dividend, but if there is a dividend, you would add it to the “Current Value”.
When we search for an undervalued stock, we want to see the opposite. We want to see a negative RoR. We want to see that the return on investment was substantially negative in that year. In our case, we look for -30%.
Why? Because this makes a stock unloved. Most of the investors and the media will turn their heads away from such stocks, and that’s exactly what Value Investors like, as now the price will be at a discount.
52 week high/low
The 52 week high shows the highest price over the last 52 weeks, while the 52 week low shows the lowest price over the last 52 weeks.
If a stock is in negative territory, it could stay there for a longer period of time, and could potentially fall even lower. That’s why we would like a certain recovery before we buy the stock.
Therefore we can add the criteria that the current price of the stock has to be 10% above the 52 week low, which means, the stock has recovered slightly.
Price to Sales Ratio (P/S)
The price-to-sales ratio measures the companies market capitalization to its revenue, or the companies stock price to its sales per share.
Market Capitalization / Revenue
or: Stock price / Sales per Share
A low ratio might indicate that the stock is undervalued, while a high ratio means that the stock might be overvalued.
As we are looking for undervalued companies, we want the price-to-sales ratio to be as low as possible. The value will differ from what is considered as low for the sector. You might have to play around with the value depending on the companies you want to find. Apple, Google, and other well-established companies will have usually a significantly higher P/S ratio.
Long Term Debt to Equity Ratio (LT Debt/Equity)
The long term debt to equity ratio measures the leverage a company is using to finance itself.
LT Debt/Equity = Long Term Debt / (Common stock + Preferred stock)
If the number is high, it means that the company took on a lot of leverage, and might be in greater danger to default, if the cash flows go down, as the company can’t pay the interest expense on the debt any longer.
This will depend on the industry the company is in. Some companies might need to take on more debt than others, hence it is a number that has to be compared with other companies within the same industry. Therefore you might have to try different values to get an output, especially in an environment, where the interest payments are close to zero.
Return on Equity (ROE)
The return on equity measures the investment return in percentage, or how well the company uses its equity to generate profits.
It is also an indication of how efficient a company is with its resources at its disposal.
ROE = Net Annual Profit / Shareholder Equity
We would like to see at least 10% ROE.
EPS Growth Next 5 Years
The earnings per share (EPS) growth over the next 5 years gives an indication of how analysts think, the company will grow over the next 5 years.
We would like to see growth of at least 10% per year.
The price-to-earnings ratio is measuring the companies share price to the companies earnings per share. The P/E ratio is used for valuing a company and determining, if it is over- or undervalued.
Companies with a high P/E ratio, can be considered as growth stocks, while companies with a low P/E ratio, can be rather considered as value stocks.
Most commonly the cut is around the P/E ratio of 15. Everything below 15 can be considered as value, and all from 15 can be considered as growth. You, however, need to consider how other companies in the same sector look like, and also need to consider the market environment. In a time with low interest rates, stock prices tend to be higher, and hence you might need to adjust the P/E ratio.
The forward P/E is a projection on forecasted earnings for the year.
We want to invest in a company with a minimum stock price of $10 per share, and avoid companies with lower share prices.
Using FinViz to search for stocks
You can visit the screener section of FinViz to get to the stock screener:
|Forward PE||Fundamental||Under 15||Undervalued|
|LT Debt/Equity||Fundamental||< 0.1||Low debt|
|Return on Equity||Fundamental||Over 10%||Profitable|
|EPS Growth Next 5 Years||Fundamental||Over 15%||Future Profitability|
|52 week high/low||Technical||10% or move above low||Bottomed out|
|Price||Descriptive||Over $10||Filter out very small companies|
Due to low interest rates, stocks are currently valued very high, so only one stock was found with the ticker symbol KBAL.
You might now want to adjust the values, if you want to adjust the criteria to the upside, to find more stocks.
The screeners can contain wrong or insufficient information. Therefore as a next step, it is recommended to take a deep dive, and look at the details, such as the Financial Statements, the Management, and other relevant information.