These are the secrets insightful investors use if they’re wondering how to know a stock is undervalued
One of the questions we get a lot is from investors trying to figure out how to know a stock is undervalued, and if that makes it a good buy. That’s a reasonable question. Don’t we all want to buy bargain stocks and watch them skyrocket in value? For many of us, though, the stock market is a little abstract.
Look at it from another angle. If you’re buying a house, there are a lot of very visible ways to determine its value. Does it need to be painted? Do the windows need to be replaced? Does it look like it could be the set for a new Stephen King movie? Those will all bring the value down. Copper gutters and a brand new slate roof? A solar-powered radiant heating system? That’s going to increase the value.
Of course, you can see those things. And figuring out how to know a stock is undervalued does take considering a few different factors than whether or not you’ll need to shovel snow from the driveway. The concept, however, is similar. When that perfect house - or perfect stock - is selling for thousands less than it “should” be, it’s undervalued (assuming it’s not the house that Tom Hanks and Shelley Long bought in the movie, The Money Pit).
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How to know a stock is undervalued - the telltale signs
The definition of undervalued stocks may seem obvious — stocks that are undervalued. This doesn’t necessarily mean they are inexpensive though. If you could buy Berkshire Hathaway (BRK-A) for $10,000 a share, that would be very undervalued. It would also be very expensive.
Still, for investors wondering how to know a stock is undervalued, there are ways to figure it out. 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. But that’s not always the case.
We like to find out why a stock is selling at a bargain price before investing. Is the company competing in an industry that is dying? Is the company suffering from a setback caused by an unforeseen problem? The most important question, though, is whether the company’s problem is short-term or long-term and whether management is aware of the problem and taking action to correct it. You can put your business acumen to work to determine if management has an adequate plan to solve the company’s current problems.
If that all checks out, then we move on to explore more in depth.
If a company’s sales are increasing every year, even when the economy is weak, we’re interested in the potential of its stock. Don’t mistake profits for increasing sales, though. Many companies are cutting costs, and that is one way to increase profits, but if their sales aren’t growing, their future growth is jeopardized. What the companies are doing is downsizing the company, which will lead to stock price erosion sooner rather than later.
One way to avoid a lot of the pitfalls of investing in the wrong stocks is to find companies that have consistently increased sales during the past 10 years and are forecast to continue to grow sales at a fairly rapid pace in the future.
Another strategy you can use involves evaluating book value. Many investors are unfamiliar with book value and book value per share, so, a quick definition is in order. Book value is a shareholder’s equity (also called retained earnings). Book value per share is simply the shareholder’s equity or retained earnings divided by the number of common shares outstanding.
Is book value per share important? By itself, no. But when compared to the company’s stock price, it’s enormously important. In short, quality companies with low price-to-book value per share ratios (P/BV) have outperformed companies with high ratios for the past several decades.
It’s also worth looking at the strategy developed by Benjamin Graham. We used one of Benjamin Graham’s value investing methods for years in our now-defunct Cabot Benjamin Graham Value Investor advisory, with great success (it closed because its chief analyst, Roy Ward, retired). The method is based upon minimum price-to-earnings ratios, price-to-book value ratios and measures of quality. The full description of this analysis can be found in Benjamin Graham’s book, “The Intelligent Investor.”
Mr. Graham suggested that value investors should buy stocks that fit all of the following criteria:
- The current price-to-earnings (P/E) ratio is 9.0 or less.
- The price-to-book value (P/BV) ratio is 1.20 or less.
- The long-term debt-to-current assets ratio is 1.10 or less.
- The current assets-to-current liabilities ratio is 1.50 or more.
- Earnings per share growth during the past five years is 1% or more.
- The company currently pays a dividend.
- The Standard & Poor’s Quality Rank is B+ or better.
What factors do you look at if you’re wondering how to know a stock is undervalued?
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