Undervalued Stocks: How to Value a Stock and Turn a Large Profit

Daniel Penzing
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In this Guide

It will be tough for you to compete with the pros, but anyone can enjoy the benefits of stock picking. I’ve been doing it for years, and it’s not as hard as you may think.

I won’t lie.

Stock picking won’t be easy. But, if you take your time, and keep learning and improving, you’ll do just fine.

If you follow the strategies in this guide, you’ll be able to buy profitable stocks and enjoy the benefits of compounding over time.

Same time frame and different stocks.

Regardless of the investing horizon, stocks that are low in price relative to earnings (P/E) will provide an above-average return.

Tools for Finding Undervalued Stocks

In order to figure out if a business is undervalued, we first need to analyze its business model. How does the company make money? How does it grow its revenue? What products or services does it offer?

Ratio Analysis

Next, we will analyze the company's financial statements, most importantly its balance sheet and income statement. More specifically, we will focus on its key profit-related metrics (such as gross margin and operating margin) and growth-related metrics.

By performing ratio analysis, it is easy to see whether the company is growing its revenue at a reasonable rate. If it pays low dividends to its shareholders, it is likely not growing its revenue at a healthy rate.

The following table is an example of what a investor might see when they perform ratio analysis on a company such as Apple. Notice that the revenue of Apple has grown at a tremendous rate of almost 64% CAGR from 2009 till 2016.

Cash Flow Analysis

Finally, when I am valuing a company and trying to determine whether it is a good investment opportunity, I like to perform a cash flow analysis.

In a cash flow analysis, I will use the company's cash flow statement to see at what price is the company trading for. According to this cash flow analysis, Apple is currently trading at a price to cash flow ratio of about 13.

Undervalued Stock Indicators

To Survive the Market?

Everybody wants to turn a profit on the stock market. But most people fail to achieve significant growth of their investment capital, and many lose money.

The single biggest reason people fail is that they believe that all stocks are valuable, and therefore hold them through their highs and lows.

On the other hand, investing legend Warren Buffett believes that all stocks are not created equal. His philosophy is that many stocks are overvalued, and in fact, some are so undervalued that they are essentially free.

What percentage of stocks are overvalued? According to Buffett, about 500 of the over 5,000 companies whose stock is listed on the New York Stock Exchange are undervalued. Unfortunately, finding shares in undervalued stocks is not as easy as it might sound. But there are a few common indicators of a possible undervalued stock. These indicators are part of the company’s stock price as well as the market as a whole.

Some of the most common undervaluation indicators that can lead to a profitable investment are:

  • Company Value
  • Technical Analysis
  • Price-to-Earnings Ratio

Low price/earnings ratio

This is a very simple concept, and any tips for undervalued stocks must be centered around this principle. The very premise of identifying undervalued stocks is that the company is growing, but its stock is not.

The main reason for this discrepancy is the individual price/earnings ratio of the company. In essence, you should try to invest in companies with the lowest price/earnings ratios.

This gives the company an edge compared to other companies and, thus, enables it to continue or even expand its earnings despite its low stock price.

Lagging relative price performance.

A classic value stock is one that has lagged its industry in price appreciation over a considerable amount of time, even after adjusting for any market events that explain the relative underperformance. This disconnect means that the stock’s price has either not been high enough to adequately reward investors for the risk they’ve taken or the business has performed poorly.

The investor will seek to acquire the stock at a lower price than the business’s actual perceived value. Generally, this is done by buying a stock in a recession or market downturn because stocks seem cheaper.

As the market recovers, the investor is positioned to take advantage of the outperformance of the company’s stock price.

Low price/earnings growth ratio

A stock's price/earnings growth ratio (PEG) is meant to compare the price of a stock to its earnings growth. It is also known as the PE-G ratio.

PEG is calculated by dividing the P/E ratio by the growth rate. Say a company has a P/E ratio of 10 and an earnings growth of 5 percent. This gives you a PEG ratio of 2.0. It is usually more favorable to buy stocks with a PEG less than 1.0, as this indicates a good value.

It's also possible to get the PE-G ratio for specific years. For example, a company might have had a P/E ratio of 8 last year and one of 15 today (30 percent growth). This gives you a PEG ratio of 2.8; not great, but not terrible.

High-Dividend yield

Stocks – Publicly traded companies in the world affect our daily lives very much. They produce a product or service and it either meets a demand or not. To sell their product, they market it utilizing many different kinds of marketing, some are even innovative. A good example is home depot who sold a set of kitchen knives with an orange safety cover, so that it could not be placed in the dishwasher helpline Cutlery. The marketing campaign was a great success for the company.

There are two ways a company can make money. One is to produce a great quality product and sell it for a maximum profit and the other is to sell a product or service that is mediocre at best. This second company can only make money by jacking up the prices of their product. Some companies do not feel they are producing a quality product and go with the second option.

There are three different classifications of stocks that I like to call value stocks because of their undervalued quality. One type of stock is a 10 year dividend paying winner, another is a blue chip stock. The last classification I like is the stock that is undervalued and has the ability to produce passive income to the investor.

Low market-to-book ratio

One way to value a company's stock is to look at the market-to-book ratio. This indicator is widely used by investors to value a company. S

Imply put, the market value of a company is the price at which the stock is currently trading at, and the company's book value is the net worth of the company. Some investors prefer to use the stock's market-to-book ratio because it allows them to measure the value of the company's stock against its total liquidity.

In other words, market-to-book will help you determine whether the stock price is an accurate reflection of the underlying value of the stock. To get a true sense of the value of the company, you should always look at market-to-book over market capitalization.

When looking at market-to-book ratio, you want to look for companies with a book value greater than 2. Looking at market-to-book ratio will give you a true sense of the value of a company's stock, but you also have to take into account a number of other factors. For example, you want to make sure that the current revenue trend of the company is positive and that the net income is increasing.

Free cash flow

One important aspect in determining the value of stocks is free cash flow. Free cash flow is the amount of money left over from day-to-day business operations. By using this figure, you can avoid trusting the financial statements issued by the company.

A company’s financials can be manipulated to portray either a favorable or unfavorable picture of the company’s financial health. Case in point, Enron.

Since the bottom line in the financial statements is the black or red ink, you can easily refine the figures to make the company appear to be in a favorable financial situation.

It just takes a little creativity. Enron used the practices of mark to market and mark to model, a creative way of recognizing revenue that would probably never materialize and transfers losses to future periods. With these two accounting practices, Enron was able to produce years of impressive financial statements while the company crunched the numbers in a way that was favorable to the company. By using free cash flow, you can eliminate the possibility of using phony accounting practices to game the system.

Professional analysts use free cash flow to measure the underlying intrinsic value of a company. They look at the company’s market share in the industry, the strength of their brand, and the future prospects of the company. By using these factors, they can forecast the future prices of the stocks based on the estimated cash flow.