The name of the game in finding undervalued stocks has always been based on a timeless truth: if you find something and buy it at a low price, you can then turn around and sell that same thing at a higher price, for a profit. It’s the golden rule of finding profitable stocks and in this article we are going to show you how to spot undervalued stock opportunities so that you can have more winners, more often.
But before we give you those five tips we have to root you in the fundamentals. In this sense it’s answering the question: “how do stocks become undervalued in the first place?”
Undervalued Stocks and How They Become That Way
The answers are many but here are the most common reasons:
- When companies do worse than expected, analysts and investors take a dim view, often punishing the stock by poor coverage or in the case of investors, outright selling the stock. Expectations are never scientifically set, but there is always a broad range of possibilities that guide analysts and investors. You’ll see this phenomenon at play when a company announces earnings which fall below what was set as a consensus estimate. A stock can come under undue pressure because of these whims, thus becoming undervalued.
- Another reason stocks become undervalued is when there are dramatic shocks in the markets, such as a crash. The big fallout in 2008 was a good example of this. Companies that were seemingly very solid in terms of earnings, overnight became lemons, promoting many investors to pull out their support.
- Then there is the unpredictable nature of a company’s industry or sector. Turbulence or even cyclical fluctuations can factor their way into a stocks valuation for good or ill.
Undervalued Stocks – What Happens When They Explode
Needless to say the outlined reasons for undervaluation can offer up significant opportunities for investors who do their homework and realize that what is being called undervalued is perhaps nothing more than bad sentiment.
Take Netflix (NASDAQ: NFLX) for example. In the past many analysts were saying that it was undervalued and many investors believed them. Fast forward to the present state of affairs and NFLX has gained 98.5% since the start of 2017. Analysts and investors alike also felt the same way about Micron Technologies (NASDAQ: MU); after posting spectacular results the stock is now up 113%. And we can’t forget to mention NVIDIA (NASDAQ: NVDA), another stock that was derided in the financial press as being undervalued and going nowhere fast. Over the last 12 months the stock has risen 188%. That’s some serious growth for undervalued stocks.
So, how can you spot them?
Undervalued Stocks – Use These 3 Metrics to Unearth the Best Opportunities
A good way is to use the PE ratio. You arrive at a stock’s PE by dividing current price by annual earnings. From there you can see how the stock’s PE compares with the average in its industry or sector. If a stock’s PE is significantly lower than average then it might be an indication that the stock is undervalued and accessible (cheaper).
A stock could be deemed undervalued if the market prices it significantly below other companies that have a lower Return on equity (ROE). ROE is a very good measure of how well a company does with the funds invested in it. A strong ROE above the industry average with an attendant lower price may be an indication that a stock is undervalued.
Debt, and its management, is also a good indicator of how well a company is doing overall. Since debt holders have priority over a company’s resources, the debt to equity ratio is always a good metric to analyze when looking at a company. If a company has a strong metric, i.e. lower debt as opposed to equity, and is nonetheless coming under pressure relative to its peers, it might be an indication that the stock itself may be undervalued.
Once you integrate these three metrics with some time-tested due diligence, you are then on your way to spotting and then executing on the top undervalued stocks. Of course all of that might involve work and you might be a bit busy. In that case you can take a shortcut and subscribe to a newsletter that prides itself on finding undervalued stocks. You can take a look at this one — it’s free to join.