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How to Identify Undervalued Stocks

Knowing that stocks are undervalued is the easy part. Figuring out how to identify undervalued stocks is the real challenge.

The broad markets have entered correction territory, and the growth-heavy Nasdaq has been trending lower for several months. With inflation, pending Fed rate hikes, and uncertainty over both the still-ongoing pandemic and international tensions, predicting the market’s future would be a fool’s errand. That’s why it’s important to learn how to identify undervalued stocks and not just “cheap” stocks.

One system for identifying value stocks is based on Benjamin Graham’s intrinsic value methodology. This value investing system calculates Maximum Buy Prices and Minimum Sell Prices for prospective value stocks.

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Quite simply, you buy a value stock when it’s trading below its Maximum Buy Price and sell it when it exceeds its Minimum Sell Price.

To do so, an investor breaks value stocks down in four ways: Quality Rating, Value Rating, Growth Rating and Technical Rating.

The Quality Rating is a measure of:

(1) The financial strength of the company’s balance sheet;

(2) The risk and volatility of the company’s stock; and

(3) The stability and consistency of earnings and dividends (if paid) calibrated on a scale of 0 to 5.00.

The Value Rating is a measure of:

(1) A comparison of the current price to earnings, price to cash flow, price to book value, and price to sales ratios to the historic norms for the company;

(2) A comparison of the growth rate for the company to the current price to cash flow and price to earnings ratios of the company; and

(3) A comparison of the latest price of the stock to the Maximum Buy and Minimum Sell Prices calibrated on a scale of 0 to 5.00.

The Growth Rating is a measure of:

(1) The historic growth of revenues, cash flow, earnings, dividends and book value during the latest five to 10 years;

(2) The risk-adjusted acceleration of revenues and earnings; and

(3) The three to five year forecast growth for revenues, cash flow, earnings, dividends and book value calibrated on a scale of 0 to 5.00.

The Technical Rating is a measure of appreciation potential derived from the leading rating services such as Value Line, Standard & Poor’s, Zacks and Investor’s Daily Business together with the stock’s price strength during the latest one-, two- and three-month periods calibrated on a scale of 0 to 5.00.

Investors combine those four ratings for a Total Rating, and target stocks with a Total Rating between 8.00 to 10.00.

But there are more basic ways in determining how to identify undervalued stocks. Those include looking at ratios such as price to earnings, price to sales, price to cash flow and price to book value—in all cases, the lower the better!

Other methods are less scientific, and don’t involve numbers. Often, the stocks that make the best value plays typically have strong sales and/or earnings growth, and the market either doesn’t fully understand or appreciate the product yet or has punished the stock for an embarrassing headline that doesn’t truly affect the company’s long-term growth trajectory. Perfect recent examples include Netflix (NFLX) when it tried to split into two websites, or Lululemon (LULU) when the company’s founder made offensive comments about the types of women who “should” be wearing their athletic gear.

If you bought those stocks in the weeks and months that followed those public missteps—when all the bad headlines had prompted knee-jerk investors to punish them too harshly—you made a pretty penny. That, in a nutshell, is the value investor’s mentality: “Be greedy when others are fearful,” as Warren Buffett once said.

Bottom line: there’s no one answer to the question of how to identify undervalued stocks. But with so plenty of good companies getting seemingly left out of the market’s cyclical rallies over the last year, now is the time to be asking it.

Of course, if you just want someone to just tell you which value stocks to buy, you can always subscribe to Bruce Kaser’s Cabot Undervalued Stocks Advisor!

What is your personal methodology for identifying undervalued stocks?

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*This post has been updated from a previously published version.

Chris Preston is Cabot Wealth Network’s Vice President of Content and Chief Analyst of Cabot Stock of the Week.