Knowing how to find undervalued stocks is the key to success in obtaining high returns in the stock market.
Naturally, the question is, how do you find undervalued stocks to invest in? And more importantly, how do you find undervalued stocks effectively?
Answering these two questions will help you save plenty of time and money by avoiding obvious dead-end paths, thereby maximizing your stock market returns.
In doing so, we'll cover three key steps: determining how to find undervalued stocks, finding the necessary information on a company's financial statements to determine if a stock is undervalued, then finally, using that information to make an informed investment decision.
While there are many methods to use, you will learn a method you can use immediately to find the stocks that will make all the difference in your portfolio in this article.
Why do stocks become undervalued?
Stocks become undervalued for a variety of reasons. The best way to grasp why a stock is undervalued is to consider what Benjamin Graham taught Warren Buffet. The stock market, in the short term, is a voting machine, but in the long term is a weighing machine. This means in the short term, the stock price can be influenced by all types of factors that are unrelated to the company's success (economic conditions, interest rates, inflation, large share sell-outs, etc.) But in the long term, what really influences the stock price, is the actual performance of the underlying business (sales, popularity, income, product success, etc.).
Taking advantage of this paradigm can open up many buying opportunities where the price of a stock is lower than the actual value of the business. So let's dive into how to find undervalued stocks.
Step 1: Use a Stock Screener
Stock screeners are often underutilized because investors expect to get investment answers by just glancing at different metrics. While that may sometimes be useful, stocks represent real, far more complicated businesses. Performing a lazy analysis may lead investors to end up disappointed.
Before using a screener, it is recommended to form an idea of the types of companies you are trying to invest in. Understanding many companies is very difficult, but studying an industry or only a few related stocks is much more manageable and could increase your odds of success.
The other reason for doing this is that it will help you significantly narrow your stock choices and force you to pick your favorite. Once you have determined your stocks of interests, then go to the screener.
Stock Screener Ratios (the PE ratio is not everything)
My personal recommendation is the TradingView screener, where you can filter your stocks based on fundamental metrics such as the ROIC, PE ratio, PEG ratio, industry, sector, price to sales ratio, book value, market capitalization, etc.
The best part about this screener is that it's very intuitive to use and covers a large number of stocks from different exchanges.
Keep in mind, traditional metrics like the PE ratio and price to sales ratio have become less relevant over the years. Instead, the most important metrics to look at are the PEG ratio, debt to equity, ROIC, ROE, free cash flow, earnings yield, and free cash flow to sales.
If you want to look at what metrics to look for, check out this article explaining different key metrics and the general rules for interpreting them.
Once you have found a stock that catches your attention based on these ratios and how it compares to its peers, it's time to move to Step 2.
Step 2 Dig Deep into the Business
Once you have found an attractive company, it's time to do the most challenging part of the research and seek to understand the business.
The best way to begin the process is to start by reading the company's annual 10k report. You can easily find this report by typing the company name followed by "10k report" on Google.
Your goal is to understand the business market, strategy, and management.
After this, you should seek to understand the business more from a different perspective and research specific questions you may have like the forecasted growth of the industry, how competitors are doing, etc.
Understand the Company's Management
A critical but often overlooked factor in a stock's success is the company's management team. For this reason, I recommend you dedicate a portion of your research to understanding the company's leadership team.
A generic Google search can tell you a lot about the company story and who the leaders are. Using the Warren Buffet criteria of looking for managers who have intelligence, motivation, and energy is a good start. Then, on top of these criteria, you can use things like an executive's years of experience, training, education, previous positions held, etc.
One last trick is to look at the employee reviews of the managers by visiting sites like Glassdoor, where you can see employee ratings and comments.
Step 3 Do Your Financial Analysis
Now that you understand the company, its management, its market, and its direction, it is time to look at the company's financial statements.
What you are looking for here is to see the trend and direction in which the numbers are going. An easy way to do it is to use Wisesheets, where you can just enter the ticker and select annually or quarterly and get all of the company's financials on your spreadsheet immediately.
From here you can use graphs to aid with your analysis or any calculations you desire.
Assuming the financial statements look solid and are trending in the right direction, the next step is to use your knowledge from all of your previous research and conduct a financial analysis. Many experts recommend using discounted cash flows to find the intrinsic value of a stock (the price you should pay for stock) but it's not always necessary to do so. Often times the best way is to look at the past growth trends and estimate based on your knowledge.
A simple way to do that is to pick a metric that is relevant for the company, like the net income or free cash flow, and estimate what that will be in the future (however long you are holding the stock). Then use a ratio like free cash flow to sales to determine the impact on the stock price.
Keep in mind that estimations are often wrong, so it is important to use different scenarios like the worst case, most likely case, and best case. The key here is not to let your assumptions be biased, so you should start with your most likely case, estimate the worst case, and then do the best case after. A bad-case scenario should be at least somewhat likely, but not probable. The same goes for the best case, it should be something that has a sizable probability of occurring.
The Stock Price
The key factor to your potential return is heavily dependent on the stock price. Sometimes no matter the quality of the company, the stock is too high priced, and it is very hard to make a return.
For this reason, the best option is to use the =WISEPRICE function from Wisesheets so you can find the stock's latest price and update it as often as you like right where you are doing your stock analysis.
Once you have the stock price, you can calculate the expected return for the different scenarios you created. If the return you calculate is satisfactory even in the worst-case scenario, then you have found an undervalued stock to invest in.
However, often times the return can be minimal or negative, and it's important to not settle but instead select a return that you think is fair. Then calculate the stock price for you to earn that return. This is what is often referred to as the target price.
As you now know, a good stock analysis process is often lengthy, but once you do it for a company, you can always refer back to your example and update your financial analysis based on any new findings.
If you want to learn more about how you can get stock financials, key metrics, and growth metrics directly on Excel or Google Sheets in seconds, check out www.wisesheets.io
To your investing success,
The Wisesheets Team