Many investors dream of finding undervalued stocks. Imagine buying Netflix, before it became a household name. For a good part of 2002 and some of 2003, Netflix was trading under $1 per share. A penny stock!!
Fast forward to 2018, and it has a larger market cap than Disney. A $10,000 purchase of Netflix stock on Sep 29, 2002 was worth over $5.6M in July 2018.
A stock is said to be undervalued if it is trading below its intrinsic value. However, often times a stock will trade based on its future prospects. That said, projecting the future is speculative and it requires making assumptions and guesses. This can be especially challenging when making projections in new sectors, like social media and block chain.
Now, that doesn’t stop analysts and investors from trying to figure out what the value of a stock is. In fact, one of the greatest investors of all-time, Warren Buffett, is considered a value investor.
Value Investing – What Undervalued Stocks Look Like
Value investing was introduced to the public by Benjamin Graham and David Dodd. The two wrote the book Security Analysis, which laid the foundation work of value investing.
Value investing is the art of buying stocks that appear to be cheap according to some fundamental metric. Famous students of value investing include billionaire investors Warren Buffett, Charlie Munger, and Mario Gabelli.
How can the market be wrong?
From time to time, sentiment can change quickly from being overly positive to overly negative. Value can be discovered during periods of volatility.
When most investors were panicking and getting out of stocks during the financial crisis, savvy investors like Warren Buffett were making strategic investments in beaten up banks like Goldman Sachs and Bank of America.
You see, for an investor like Buffett, he knows that sentiment can shift in the near term. However, when he invests in a company, he has a long-term plan. He has been quoted in the past as saying: Buy it thinking you will hold it forever.
Some metrics value investors use to try and uncover cheap stocks are: PE Ratio, PEG Ratio, book value, and free cash flows among others.
That said, a company’s stock can be undervalued relative to its industry as well as its own historical data.
When new information is released it takes time for market participants to interpret and decide what it means to the company’s stock price.
Undervalued Stocks – Metrics
Here are some of the most popular metrics analysts and investors use to help determine a stocks valuation:
PE Ratio: The ratio of a stock’s current price to last year’s earnings per share. The price-earnings ratio tells us how much we can expect to invest in a company in order to get one dollar of that company’s earnings.
Intel Corp is the largest semi-condcuter traded. Generally, companies that are mature have a lower P/E ratio and companies that are considered to be growing have a higher P/E ratio.
However, making decisions on this metric alone could –lead you to miss opportunities. For example, Amazon has historically had a high P/E ratio and has been among the top performing stocks over the last decade. In addition, companies that post losses do not have a P/E ratio.
Enterprise Value: The market value of common stock + market value of preferred equity + market value of debt + minority interest – cash and investments.
Use this metric to compare companies in similar industries.
When Greenlight Capital took a stake in Twitter, it noted that the company had an enterprise value of just 2% of that of Facebook, the largest social media company in the space. Greenlight made the move because they thought that twitter was an undervalued stock.
Despite Twitter having a large user base and broad market reach, Greenlight believes that it is a value relative to its competitors.
Free Cash Flow- This metric tells us how much cash a company can put together after its required investment obligations.
The amount of free cash flow is important because it tells us if a company can pursue M&A, R&D, expand business, distribute dividends, or do stock buybacks.
That said, if a company has a negative free cash flow, don’t be fast to dismiss them.
How You Can Find Undervalued Stocks
For the most part, when a Wall Street bank gives out a buy or sell recommendation on a stock, they’ll base it on fundamentals. To help build their thesis they will use financial models.
The Discounted Cash Flow is a valuation model that analyzes the future free cash flow estimates and discounts them, through a required annual rate and arriving to present value estimates.
Generally, if the”DCF” is higher than the current cost of investment, it is potentially a favorable opportunity.
Another valuation technique that can help to find undervalued stocks is peer company analysis. It’s a side-by-side comparison of companies in the same sector. Some common valuation comparisons include: P/E, Fwd P/E, P/FCF, P/S, Enterprise value/EBITA, dividend yield, profit margins, and EPS to name a few.
Market pundits often tell you to invest in “best of breed” companies. These are typically the ones that have the largest market cap, leading in sales and growth or some of the other valuation metrics previously mentioned.
Using a stock screener like the one on finviz.com, makes it easy to do some valuation analysis.
In addition, it is important to read quarterly earnings statements and follow news on companies you are interested in.
Valuation is an art form. No one can really predict the future and because of that investment opportunities arise. Value investors like Warren Buffett have a long term perspective.
Now, for today’s investors, thinking long term can be challenging. For example, Google, Amazon, and Facebook are among the largest companies in the world, and Amazon is the oldest of the three, and it is just in its 20s still.
Will new companies come along and dethrone the current best of breed?
Most likely, that is, if the past is an indicator. Companies like General Electric, American International Group, Eastman Kodak, Sears, Goodyear Tire, Bethlehem Steel, and Westinghouse were all once part of the Dow Jones Industrial Averages.
With technology changing rapidly, the concept of value of investing becomes difficult. However, using concepts like relative value and peer analysis can be helpful when making investment decisions.