How to Find Undervalued Stocks?

“Price is what you pay; value is what you get.”

Warren Buffet

Finding undervalued stocks may appear tedious and hard. Depending on how you do it, it definitely can be. Luckily, we’ve compiled a list of key considerations, metrics, and tips to make the process of finding undervalued stocks easier. But first, what does it even mean that a stock is undervalued?

What is an undervalued stock?

A common misconception between the stock price and fair value

A common misconception about stocks, and their value, lies in the price of a stock. At first, many people think that the price of a stock determines its value, so one can simply compare the prices of stocks and find which are undervalued. However, this is not true. A stock, or share, represents the price of that share of the company, and the amount of shares in a company varies from one company to another. Therefore, finding the value of a stock is not about the price of the stock, but rather the fair value of the stock, and thereby the company as a whole.

While the price of a stock can be the fair value of the stock, it can also be above or below, so when finding an undervalued stock, we wish to find a company whereby current stock price is lower than the fair value. The degree to which stocks are fairly priced varies on market efficiency: how close is the fair value to the current share price, and how quick is the market to react to news about that stock to reassess the fair value.

The two main methodologies

There are two broad methods of estimating the fair value of a stock: Absolute (or intrinsic) valuation, and relative valuation.

• Absolute valuation: A methodology of intrinsic valuation, conducted by estimating future cash flows and discounting them back at a discount rate to achieve a current fair market value of the company and fair value share price.
• Relative valuation: A methodology of relative valuation, by comparing a selected company to its peers and industry through financial metrics to judge the relative value of the company compared to its peers and industry.

The pros and cons of both methodologies

Absolute valuation requires estimates of future profitability, increasing your chance of misestimating inputs which may throw off the final estimate of the fair value. Even the best analysts have trouble estimating future cash flows as this is a forward-looking estimate, which is inherently unpredictable. If your estimates are correct, an absolute valuation will give you a fair market value and fair share price to compare with the current share price.

Relative valuation requires you to find suitable peers, preferably in the same market and industry with similar operating models and financials; the closer the peer the better the comparison. Alternatively, one can compare to the industry average or the average of a group of peers for a more robust comparison. However, sometimes there are no similar peers so the relative comparison can be difficult and require comparisons across markets or industries. Moreover, sometimes the whole industry can be overvalued or undervalued, in which case any relative valuation will be relatively correct compared to its peers, but the fair value of the company will be incorrect.

In this article, we will explore relative valuation as a simple method to explore fair valuation with the goal of finding undervalued stocks.

Why do stocks become undervalued?

Generally speaking, the main reasons for stocks being undervalued are:

• Analyst coverage
  • Generally, stocks that have a larger market capitalisation have more analyst coverage and their markets are more efficient, meaning the chance of finding an undervalued stock is lower as you are essentially competing for the best estimate against professionals. Vice versa, with lower capitalisation stocks, there may be little or no coverage, increasing your chances of finding an undervalued stock.
     
• Adverse news
  • Adverse news may bring forth a worse outlook which can affect the company, sector, or the industry as a whole. This may decrease the estimated future profitability of a company and in turn, the share price, which may be justified or an overreaction, depending on the company.
     
• Cyclical fluctuations
  • Cyclical fluctuations in both the stock market and economic cycle mean that depending on the current stage in these cycles, sectors, and their constituent companies, perform differently. For more information on cycles and sectors see our article: Sector Concentration Risk – Are you too Overweight in Certain Sectors?
     
• Underperforming results
  • Companies periodically provide future outlooks and report their financials on a half-yearly or quarterly basis, depending on the market in which they are listed. If the reported financials fall short of the outlooks, as estimated by the management and analysts, the share price often decreases.
     
• Market crashes/corrections    
  • Corrections and market crashes, like the coronavirus-induced market crash in March 2020 or the GFC in 2008, often cause the share prices of companies to decrease, which again may be justified from the worsened company outlook or simply be an overreaction caused by panic selloffs.

How to find undervalued stocks?

Finding stocks

To narrow down the universe and find stocks that may be undervalued, we recommend either picking companies you know well or believe to be undervalued or simply using a stock screener such as Maqro’s Stock Screener.

If you’re selecting stocks on your own, compare the metrics to the industry averages as well as the selected peers for your companies to find companies that offer better value. Otherwise, if you’re using the Maqro Stock Screener, screen for the below metrics and values, keeping in mind that they should be screened based on the average of the peers within their industry, and the industry average as a whole.

Using relative valuation

The following financial metrics and ratios will be useful for determining the relative value of your company and its stock compared to its peers. While there are other useful metrics, these cover the basic relative valuation metrics:

Price-to-Earnings (P/E)

P/E ratio is the most common relative valuation metric, measuring the relative price of the stock compared to its earnings, or net income. A P/E ratio of 20 means that the market prices the stock at 20 times earnings. While industry averages for the P/E ratio vary significantly, the lower the P/E ratio the better value. This does not mean that undervalued stocks can’t have a high P/E ratio, as stocks can be posed to have significant growth in their future earnings. In general, high-growth industries, or industries with more certain cash flows, have higher P/E ratios.

Price-to-Earnings Growth (PEG)

The PEG ratio takes the P/E ratio and accounts for future growth estimates of the company, by dividing the P/E ratio by earnings growth rate. While P/E measures past earnings compared to its equity, PEG accounts for future earnings growth in its calculations. In general, a PEG of less than 1 is considered to be undervalued as its price is low compared to the company’s expected earnings growth. This calculation is harder to nail as future earnings, and thereby earnings growth rates, are unpredictable. That being said, it is very useful as a comparison tool across industries.

Return on Equity (ROE)

ROE is a measure of profitability, measuring the percentage of a company’s profitability against its shareholders’ equity. Essentially, it measures the return on the shareholders’ equity, although the precise value for what is good or bad varies between industries.  A higher ROE is better, as the company is then more effective at generating profits from its existing assets. An increasing ROE signals increasing operational and financial efficiency, so finding a company with a high and increasing ROE is a good sign.

Price-to-Book (P/B)

The P/B ratio is a measurement of a company’s market value of equity, or market capitalisation, to its book value. It is calculated by taking assets minus liabilities and dividing by the number of shares outstanding. P/B ratios are generally over 1, so finding a P/B ratio under 1 is typically a good find as the value of its assets on a per-share basis then exceeds the price of the stock. For companies with inconsistent earnings, this measure is especially useful.

Debt-to-Equity (D/E)

The D/E ratio measures the proportion of debt to equity. This measure can vary from 0 to over 2, and therefore elicits the highest variance between industries. While some industries are highly leveraged, like the banking industry other service industries like wholesalers have some of the lowest leverage. Even within industries, D/E ratios can exhibit great variance due to different approaches to capital structure, so understanding the underlying capital structure and strategy is essential.

Dividend Yield

Lastly, high dividend yields, measured as dividends per share (DPS) divided by the current share price, can hint at an undervalued dividend stock. While dividend yields can change substantially throughout the year, especially post the ex-date of dividends and after a price correction, a history of solid dividend yields hint at substantial profits and an undervalued stock. For more on dividends and Maqro’s top 3 dividend stocks, see our “Guide to Investing in Dividend Stocks”.

Maqro Tip: Be wary of buybacks and share issuances, as buybacks decrease the amount of shareholder’s equity, increasing ROE, P/E, and PEG, while share issuances have the opposite or an inconclusive effect on the same metrics. Moreover, high use of debt can also skew ROE, P/E, and PEG ratios, so utilising all of the above metrics, and more can help gain a greater understanding of a potentially undervalued company.

While these metrics are useful, there are additional ratios to help screen and evaluate stocks. Ultimately, the goal through the screener and relative valuation is to compile a list of stocks for further analysis. Hereafter, both qualitative and quantitative analysis of the company’s management, strategy, outlook as well as past, current, and future expectations of performance should be considered to provide a complete view.

In summary

While there are varying methodologies, each with its pros and cons, screening for stocks based on certain metrics can help you narrow down your universe on stocks before conducting further analysis. Utilising a stock screening tool, like Maqro’s Stock Screener, together with additional insight into the company, through the Maqro Portal, provides you with a holistic overview of the company. Either way, financial metrics should not be the sole measure, as insight into the companies’ idiosyncratic characteristics and future outlook should also be accounted for to find undervalued stocks.