You don’t have to be Warren Buffett to know how to find undervalued stocks. Finding undervalued stocks is not an easy task. There are many factors you have to consider.
Trading under book value
While low book value per share and low price-to-earnings can be deceiving, and requires investors to do some due diligence and analyze in depth the company’s financials. You will often find companies selling under what their assets are worth minus liabilities. Try to avoid situations where the book value has been decreasing, or the company has multiple depreciating assets. Sometimes you will find companies often in beaten down sectors that you should avoid. Despite trading under book value, the equity value is continuously decreasing, and that is the reason why the share price is so low. This varies by industry, so keep that in mind.
Trading under cash
Not as often as stocks trading under book value, but sporadically there are stocks trading under the cash they hold. Meaning the company has more cash in its balance sheet than the stock price. Be careful with some sectors that due to their specific operations require that companies hold a lot of cash. Namely the banking and insurance sectors. If you can find this type of opportunities, you should research the company extensively. As an investor, try to fully understand why the stock is priced so low. Often you will find that the market overreacts to negative news. Exploit situations where the stocks are overly shorted and oversold can be extremely profitable investments for the patient and long-term oriented investors.
Sometimes companies hold multiple investments in other companies that might offer value. This is what is commonly referred to as an Asset Play. In some situations the whole market capitalization of the stock might be lower than the company’s total investment portfolio. These are some of the best value situations you can find. It requires you to analyze every investment the company owns to make sure they are fairly priced. If so you are essentially buying the company’s investment portfolio at a discount and get the company for free. Avoid situations where the investments are overvalued. This may give you a wrong perspective on the value of the whole business. You should also be on the lookout for companies with shrinking revenues and profits. The apparent cheap price might signal negative future prospects for the business.
You can find undervalued stocks among growing companies. Growth stocks often have a higher price-to-earnings, as higher expected earnings will usually lift the stock price. Despite the higher price, you can often find opportunities in sectors you are knowledgeable about that might offer great upside. You should look for companies that are growing but have lower price to earnings ratio than their counterparts, stocks where the growth might be higher than anticipated, and finally companies who become profitable. Looking at companies with lower price-to-earnings and low price-to-cash flow ratios is the best starting point. Try to analyze them in comparison with their competitors, and ask yourself why is the p/e lower?
As for companies that might grow more than expected, you should look at sectors that are trending. Ask yourself what companies are operating in the space that might have a competitive advantage and might grow faster than estimated. Lastly, try to look for stocks that aren’t profitable and will eventually become. This is a great way to ensure you book a great return, mainly because when a company becomes profitable the general market usually attributes higher price, essentially repricing the company. As analysts change their models based on positive discounted cash flows the price of those stocks moves upwards. With this in mind look for companies where management is top notch, and has been delivering results according to estimates or above.
Special situations are far more common than some of the examples above. There are many stocks that can be profitable situations but present a higher degree of risk. Over leverage can happen for many different reasons. Although I would advise you to look elsewhere for value there can be some very good opportunities among indebted companies. Try to understand exactly why the company has accumulated so much debt and what did management do with the capital. Consider what is the management’s attitude towards the debt and how it is being repaid. Focus on companies in which there is a positive change happening, like paying down debt faster than expected, or a great operational improvement that can lead to lower debt faster. Source: Insperity
M&A that didn’t go as planned
Mergers and Acquisitions don’t always go as planned, and this can provide investors with great returns. A company might pay a much higher price than the value of the acquisition. It could also find some challenges integrating its operational segments. When situations like this happen you will see the stock price usually descends. Similarly to the over leveraged stocks you should look for a positive change happening. Understanding why the Merger or Acquisition didn’t go as planned is another important step. You should also consider the debt, usually M&A might be done with borrowed money and it’s important to put that into perspective when considering that kind of stock.
Commodity driven stocks
Another interesting situation investors should consider are stocks driven by commodity prices. Mining stocks for example are usually moving according to commodity prices. Understanding commodity price movements is incredibly easier if you compare it to stock analysis. Despite the challenge in analyzing commodities, the reality is their prices are mostly driven by supply and demand. Understanding how the supply and demand work, and how it is traded globally are the two main goals here. With that in mind you can find commodities that due to fluctuations in supply and demand will either rise or fall. This can be an interesting opportunity to exploit, and find undervalued stocks. You can then look for stocks that are driven by those same commodity prices. Source:Kiplinger
The market is usually efficient. However there are always undervalued stocks in bull and bear markets. A stock price is essentially the market consensus on the value of a certain business. This is the main reason why investing is so complicated and time consuming. When you place a trade you are going against the general consensus. Either thinking something is worth more or less. To be successful you need to accurately decide if something is worth more or less. While at the same time, determine that the general consensus is attributing a price that is incorrect. Follow some of these ideas and you will certainly know how to find undervalued stocks.
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