Even with tariff fears (and worries about rare earths) bubbling up again, the headline indexes are either trading at or knocking on the door of all-time highs, and risk-on segments of the market (notably small-cap stocks and cryptocurrency) are garnering a lot of attention.
In other words, the bull market remains in full effect.
But stocks are trading at elevated valuations, which puts investors in a tough position, at least psychologically speaking.
That “musical chairs” feeling of waiting for the music to stop often prompts investors to start hunting for underperformers, with the idea being that undervalued stocks are a safer place to hide should things head south. There’s also the potential upshot of a rising tide lifting all boats, in the event that the music keeps on playing.
It’s a contrarian angle to be sure. Plus, there’s no denying that being greedy in sectors where others are fearful can pay off handsomely.
But it’s important to know if a stock is undervalued and not just “cheap.”
After all, cheap stocks can stay that way for a long time if they’re cheap for a good reason, whereas the market will eventually come around on undervalued stocks.
So, how do investors distinguish between an undervalued stock that’s worth investing in and a cheap stock that’s better off ignored?
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.
[text_ad]
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.
Quality 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.
Value Rating
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.
Growth Rating
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.
Technical Rating
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 of determining if a stock is undervalued. 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 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 know if a stock is undervalued. But with plenty of good companies getting seemingly left out of the market’s cyclical rallies over the last year, now is the time to be looking.
Of course, if you just want someone to just tell you which value stocks to buy, you can always subscribe to Cabot Value Investor, where I’m always on the hunt for growth at value prices. To learn more, just click on the link above.
[author_ad]
*This post is periodically updated to reflect market conditions.
