How to Find Undervalued Stocks | Undervalued Mid Cap Stocks
The main task of a trader is to buy cheap and sell expensive. It’s what really brings benefits and makes us all happy. For example, by buying shares for $ 120 and selling them for 180 after a while, the investor earns 50% per year. But how to find these amazing bargains? The answer is there: it needs undervalued actions. And there’s no better time for that than now. During the global sales time caused by the pandemic, it will be a mistake to miss that opportunity.
This article will provide all the necessary information on how to know if stocks are undervalued, what indicators should be taken into account, as well as some examples of companies in which you can invest immediately.
What are undervalued stocks?
As can be defined by the term itself, an undervalued share is a security with an undervalued market value. In short, it means that the current share price does not reflect the positive outlook of the issuer and the value of the asset is likely to increase in the future. The antipode of an undervalued stock is overvalued, the price of which exceeds the real prospects of the business. Basically, the market strives for a fair price, so the shares of undervalued companies sooner or later grow to the right value. And if an investor has managed to locate that stock, he will definitely get a decent return on that investment.
There is an opinion that undervalued shares are always issued by new companies or small companies, which have not yet proven themselves. But in reality, such shares can also be expensive securities, which are expected to increase in value. In addition, the longer an issuer is in the market, the more accurate the forecast of its behavior.
Knowing which stocks are undervalued, you can buy them in a bear market and expect a bullish reversal, and then sell them with big profits. It should be noted that investments in undervalued shares are associated with risk. The company may fall under severe sanctions and not leave. The debt burden may be excessive. There may be some fundamental problems in the management of the company. As a result, the downtrend may continue and the stock price may gradually become fair. And the investor will not be able to make money from it. It is therefore necessary to analyse in depth the reasons why the stock was underestimated. Sometimes it doesn’t come from a good life. And sometimes it is due to temporary difficulties. In the latter case, the shares must be bought, in the first, not.
How to find undervalued shares
Undervalued stocks can be found in any industry. Most often, they are issued by companies whose operations are cyclical. In certain periods, the profitability of such organizations may decline dramatically, resulting in a drop in demand for their shares. Over time, productivity will normalize and, consequently, asset values will rise again. The challenge is to buy at the time of “low” prices.
Several methods of fundamental analysis are used to find “cheap” stocks and to calculate the relationship between their market value and real. Below we will consider the main methods of searching for undervalued shares.
It is essential to understand that the decision to buy shares must be balanced and sensible. Otherwise, all trade will be reduced to News trade. Accordingly, should not rush to buy any stock, if today saw a program on the “unprecedented” growth potential of any company. It is not a technical analysis that is determined by figures. But it is better to get information from sources that you find yourself, not from those that have found it.
Investors use several indicators to determine whether a share is overvalued or undervalued relative to the company’s core data. None of them can only give an objective assessment of the document, but all of them in total help to find truly promising assets.
Price/profit ratio (P/E)
The price / earnings multiplier allows you to estimate the prospects of buying shares of different companies. The meaning of the multiplier is in the amount of money that investors are willing to pay today for every dollar of the resulting gain tomorrow. By its nature, the price-to-profit ratio shows the amount, for example, of dollars that an investor must invest in a company to get one dollar of its profits.
P / E is calculated as the relationship between the current market value of a company and its net profit-P / E = Price / Earnings.
The P / E ratio allows you to quickly compare several absolutely different companies in terms of capitalization and make the right decision in favor of those that are currently the most advantageous in terms of profitability.
For example, if the current Microsoft stock price (MSFT) is $216 and earnings per share for the last 12 months are $5.76, then P/E will be 216/5.76 = 37.5.
Generally speaking, a high price / earnings multiplier suggests that investors expect higher gains in the future compared to a company with a lower P / E. A low coefficient may indicate that the company is currently undervalued or that it has been doing much better in the last period than in previous periods. When the company has no profits and shows losses, it is impossible to calculate the price / profit ratio. In this case, you can see “N / A” in the P / E line instead of the value, or just a hyphen.
Remember that the P / E ratio should be measured in relation to the country and industry-compare the value to the industry average. It is very likely that the P/E ratio>20 indicates that the company is overvalued by the market, while the P / E ratio around ten means a fair valuation. At the same time, investors should be cautious with low P / E values.
Price/profit growth ratio (PEG)
As you can see, in some cases, the P / E ratio of many companies is above the industry average. Does this mean that this company does not deserve attention? Not at all.
The PEG indicator – price / earnings growth ratio – helps to understand this. PEG is calculated by dividing the P / E coefficient by the company’s profit growth. Yes, if the P / E ratio of the company is 15 and analysts expect that in the coming years, the company’s profits will increase annually by 20%, then the PEG of this company is 0.75. It’s a pretty favorable relationship.
PEG < 1 is believed to indicate that investors overpay for the shares of this company: the current P / E ratio is not justified by the expected profit growth. Investors give preference to companies with PEG values below 1. It should also be taken into account that the PEG of a particular share, as well as the P/E coefficient, should be considered at the same time as the average PEG value for the industry to which the analysed company belongs.
The PEG ratio is used to determine the “equity” of the value of the price / profit ratio, slightly supplementing it. A company with a high P / E ratio may not be overvalued, but it can even trade at a discount if it has a high earnings-per-share ratio. Therefore, one of the positive aspects can be considered a growth factor in the benefit of enterprises
Price / book ratio (P / B)
The P / B ratio (or you can find P / BV – Price / Book Value Ratio) is an indicator that reflects the relationship between the market value of the shares and the net present value of the asset (net assets) after all costs, in case of immediate settlement.
In simple words, the P / B ratio is the relationship between the value of a stock and the company’s inventory. This Inventory refers to everything that belongs to the owners after repayment of the debt.
P / B < 1 indicates that the market evaluates the business below its assets, which means it is a good time to invest.
But that doesn’t mean you have to run headlong in search of a company with a P / B <1 ratio.Peter Lynch said it is reckless to buy shares of crisis companies blindly, one should avoid those who have tremendous debt obligations.
The P/B ratio multiplier may indicate that the current value of the shares is correct, while the financial community usually interprets the indicators as follows:
P / B > 2-it is very likely to indicate that the company is overvalued;
P / B = 1-2 fair value;
P / B < 1-the company is undervalued.
But such conclusions are not applicable in all cases. Let’s look at the example. A company develops software to automate business processes and, of its tangible assets, has only one small building: the rest of its employees work remotely around the world, and the value of its shares may be undervalued even if the multiplier P/B = 4.
The calculation of this ratio does not apply information on the profitability of enterprises and many other analytical data.
This ratio is applicable when comparing companies in the same segment, for example, when valuing shares of several banks operating in the same region. In the case of companies where there are very few tangible assets and where products or services generate large profits, the P / BV ratio is an incorrect tool for valuing shares.
Return on equity (ROE)
Most investors call this indicator “the essence of the business” and one can agree with it to some extent, because it is ROE that shows the ability of the company to make profits for its shareholders, and also clearly reflects the effectiveness of management actions.
ROE is the relationship between the issuer’s net profit and equity.
ROE = Net Profit / equity * 100%.
The capital of the shareholders is determined by the difference between all the assets and liabilities of the company. In essence, this is the third section of the balance sheet.
Therefore, the higher the ROE, the more effective the business will be to generate equity gains. If ROE = 25% , then for every $ 100 invested, the company gets a net profit of $ 25. In addition, ROE reflects the average return on capital only (unlike ROA), which makes it a more useful (visual) multiplier for investors.
For example, here is a chart showing the comparison of Apple, Alphabet, and Microsoft ROE.
Return on equity (ROE)
Simply by taking a quick look at ROE, you can see if it is reasonable to deal with this company or not. A comparison of the ROE with the current market rate of return (r) will clearly show owners how effectively shareholder funds are used “compared to the market”.
If the ROE is consistently worse than the market rate of return, you should consider avoiding this business and investing in assets that generate market returns. For example, if a bank deposit or government bond yields a yield of 5% and ROE = 2% without a tendency to improve, then what is the point of continuing such a business?
Absolutely the same story applies to investors. If a company works less efficiently compared to the relatively risk-free rate of return in the market, it would not be very logical to expect such an investment to be successful. Naturally, this approach makes sense only for a sufficiently mature business, and also has many exceptions. For example, with a negative net profit or equity (which is not uncommon), the ROE indicator becomes useless.
As a result, ROE is a reflection of the real profitability of the business. It’s the interest rate at which shareholder money works. That’s why it’s so meaningful.
This financial indicator allows the investor to determine the return on investment and its value. It is a method for assessing the cash flow received by the investor for each unit of currency invested in the company’s capital.
The dividend yield is calculated using the following formula:
Dividend yield = (annual dividend per share / share price) * 100%
For example, here is a dividend yield on Apple shares:
One of the most attractive types of companies for investors are the so-called Dividend Aristocrats. Investments in such enterprises are considered the best option for the formation of passive income.
Dividend Aristocrats are companies that systematically increase dividend payments to shareholders. An essential criterion for granting such status is the payment and increase of dividends for at least the last 25 consecutive years.
The list of” aristocrats ” usually includes no more than 100 companies. It is because the dividend yield of shares must be kept at a consistently high level for a long time. These companies have high stability as well as excellent long-term growth potential relative to their competitors.
There is the S & P 500 Dividend Aristocrats Index, which is composed of 50 corporations included in the S&P 500 Index. Such companies are bet by investors for their profit potential, but it should be understood that high profitability is synonymous with increased risk. The higher the yield increases, the greater the risk of collapse of stocks on the stock exchange under the pressure of unfavorable situations, since every dollar paid as a dividend is a dollar that was not invested in the company itself.
Three undervalued actions
In the first quarter of 2020, markets experienced a strong shock. The spread of the new coronavirus has reached the scale of the pandemic. It could only hit many sectors of the economy, which was manifested in stock market quotes. At the end of the quarter, the US Dow Jones index fell 23.2%. As a result, even the best performing stocks are traded at a mass selling price, being too far from the fair price. Let’s take a look at some of the undervalued stocks so that
Goldman Sachs predicts that General Motors ‘ car demand will rise after the car market recovers. The advantage of the company is also a reliable position in the segment of tablets. After the restoration of real estate construction, the demand for such models will increase.
Another factor, which indicates the stock prospects of this car manufacturer, is the company’s emphasis on the Chinese market. It is recovering rapidly from the pandemic, which will have a positive impact on the corporation’s revenue. GM also expects to invest around $ 20 billion in the development of electric cars and autonomous machines by 2025. GM shares have a low EPS (5.9), which is a significant indicator for buying these undervalued shares.
With the outbreak of the pandemic, the cruise industry faced a historically complex challenge. As many countries have banned tourism and closed borders, cruise companies have joined airlines in that difficult trial. Carnival, a leading player in the cruise industry with nine different cruise brands, was no exception. Companies had to face a lot of cancellations, as people canceled their vacation plans.
A recent earnings report shows the financial damage caused by a coronavirus. Passenger ticket revenues fell 86.3 percent year on year to just $ 446 million in the second quarter of 2020, while total revenues fell 84.7 percent year on year to $ 740 million. The company reported an operating loss of $ 4.2 billion for the quarter.
Carnival’s stock price to date has fallen 69 percent year on year, although it nearly doubled from a low of around $ 8 in early April
However, positive news has also emerged this month, as some of the company’s cruise brands will resume sailing in September. AIDA Cruises will resume its operations from 6 September, with the first ships sailing from the German ports.
Given the current price and outlook of the company, Carnival can be considered as one of the best undervalued stocks to pay attention to.
How to trade undervalued shares
To trade undervalued shares, start by analyzing the eight relationships described above. Remember that while these proportions are useful, they should only be part of your fundamental analysis. In turn, it must be combined with a thorough technical analysis for a complete market analysis.