Investing in the stock market can be a worthwhile decision in your life. But success does not come that easy. Success in the stock market is all about buying low and selling high, and one fundamental trick here is to learn how to find undervalued stocks!
An undervalued stock is often priced below its actual market value. When you learn to identify the undervalued stock, then your star in the business shines bright. On the other hand, ETFs and Index funds usually have a lower risk to invest in than securities like stocks, or you can simply keep your cash in your TFSA and let it generate interest income, but those are topics for other posts.
Although there is no guarantee which stock will yield high dividends, learning the fundamentals of finding undervalued stock can help.
Keep reading to find out more.
Finding undervalued stocks requires a thoughtful evaluation of the metrics of a company versus those of competitors. You’ll then determine whether the stock will be valuable in both the short and long term. The following metrics will help you find undervalued stocks in the stock market (see also investment for beginners).
Look for Low Price-to-Earnings Ratio
This is the most common criterion to find an undervalued stock. It gives you the market price per share compared to the company profits.
To get the P/E ratio, divide the company’s total earnings per share (EPS) by price per share. So if the P/E ratio is high, it means that the stock is expensive compared to its profits or earnings.
However, the P/E ratio on its own is not sufficient consideration. It needs to be checked against P/E ratios of similar competitors in the same industry and why it is undervalued. If it’s lower than that of competitors because of negative publicity, it is likely undervalued. But if it is because of a decline in earnings, it is its potential actual value.
Like P/E, the ratio of the price-to-earnings-growth (PEG) only that it focuses more on future growth than a company’s past performance. You can get the PEG ratio by dividing the P/E by the earnings growth percentage of the company. For example, if the PEG is 20 and the projected growth is 25, the PEG will be 0.8%. (convert the result into a percentage).
If you do the same analysis (see fundamental and technical analysis) and with similar companies in the same industry and get greater values, it is undervalued (0.8%). The undervaluation could be due to varied reasons. e.g., investors could have been misled about the company’s growth rate.
When the PEG is less than one, it indicates the stock price stability in the future.
Look for Low P/B Ratio
When the P/B is less than one, it means that the market’s valuation of the company is less than the book value. The company may appear to be struggling when it is not. Suppose a competitor comes up to buy the company for a greater valuation of the stock. In that case, if you buy the stock before the acquisition, you will get high profits immediately after the purchase.
If the price-to-book (P/B) ratio is less than one, it is an indication that the company’s stocks are undervalued.
Look for High Dividend Yield
Depending on specific market factors, the stocks are discounted when a company’s dividend yield is continually high. Dividend yield, or the annual dividend, is the share of profit that a shareholder receives from a company. You can determine the share profit percentage by dividing the annual share profit by the stock’s current stock price.
If a company pays a more significant dividend yield percentage than the average dividend percentage in the same industry, it is more profitable.
A company that has consistently had a high dividend yield means that it is profitable and stable. This could indicate that it has an undervalued stock.
Again, if the factors leading to the greater dividend yield are cyclical issues or unpredictable future, it is not indicated that the stock is undervalued.
How Do You Know Stock Is Undervalued or Overvalued?
Knowing whether a stock is undervalued or overvalued requires you to do a thorough evaluation of several metrics. To avoid falling into a value trap, it will help if you take the following steps before you commit your cash into any given stocks in the market (see top ETFs, and most desirable Canadian ETFs, too).
Examine Dividend Yield and Cash Flow
Cash flow is something you need to consider when determining the valuation of a company’s stock. Companies that pay high dividend yields consistently are most likely undervalued. Dividend yields can not be separated from cash flow. If a company pays without fail, it means that it is in a solid financial position.
However, be careful of companies that pay very high dividends leaving little cash for reinvesting or paying debts.
Compare the Ratios
Checking ratios can be a helpful way to identify the value of stocks. Some vital ratios to review are:
Price-to-Earnings Ratio indicates the value of stocks in the current market. Compare the P/E of a company versus the price-to-earnings of similar companies in the same industry. To get the P/Eratio, divide the company’s profits and earnings by the price per issued share. If the price-t-earnings ratio is low, it is an indication that the stock is undervalued. Similarly, if the P/E is high, it means the company’s stock is expensive.
The debt-to-equity ratio indicates the debt of the company versus its assets. To determine the D/E ratio, divide the liabilities of the company by shareholder equity. A higher proportion of debt-to-equity indicates the company is dependent on borrowing to fund operations. In determining the value, balance the cash flow, assets, and profits. To determine if a company is undervalued, use the D/E ratio compared to similar firms in the industry.
To calculate this ratio, divide the shareholder’s equity by the book value per share. If the resulting figure is less than one, it indicates that the company’s stock is undervalued.
The total assets of the company are worth more than the total share price.
It determines the financial stability of a company. To get the current ratio, divide assets by liabilities. If the result is less than one, the company’s assets can not cover the liabilities. Hence the stock will be undervalued. If it is more significant than one, then the company is in a solid financial position. The stock will be expensive.
Analyze Competitor Pricing
To identify undervalued stocks, you can also compare what factors determine the share price of similar companies. Check what makes the share price lower. Also, find an account of the disparities in share price and the likely future behaviour of the pricing as you consider the present.
Observe how the competitor’s stock price is trading and whether it reflects the stock’s actual value. The determination of the true value will help you identify whether the stock is undervalued or otherwise. It might be that the stock price of the other company is overvalued than what you are looking at.
How Do You Calculate Undervalued Stock?
There are many ways of calculating the value of a stock. It is essential to consider several dynamics to determine stocks of undervalued companies because no particular method is sufficient. Companies operate differently: Some have free cash flow while others do not. Others may not have a net income or an operating income, while others do (see also preferred shares, fixed income assets). As a result, you need to look at the value of the stock from several angles. The following are some comprehensive ways to calculate undervalued stock.
Enterprise Value-to-Sales (EV/S)
Enterprise value is used in place of market capitalization and takes debt into account. It is suitable for companies that are not listed publicly. To calculate enterprise value-to-sales for private companies, add the stockholders’ equity plus total debt, then subtract cash. To calculate EV/S for public companies, use the market cap, add total debt, then subtract cash.
Which Stocks Are Currently Undervalued?
An undervalued stock is bound to be profitable in the future, despite its current market price. Investors may presently shun away from investing such shares due to misleading information or even lack of it. Undervalued stocks are valuable to buy and hold until when it is clear that they are profitable.
Some of the undervalued shares currently are:
Absolute Software, trading as TSX: ABST and as NASDAQ: ABST, is an undervalued stock. The company is likely to gain from a rise in cybersecurity threats. It also has plans for global expansion. Currently, its stock is cheaper than those of its competitors.
Trading as (TSX: SU)(NYSE: SU) Suncor is cheaper than its true value. Its NTM EV/EBITDA is about 20% lower than that of similar companies in the industry. Its stock is currently affordable, and its growth is solid due to the high energy demand. It has been cutting down on its debt and making repurchases, not to mention its consistent payment of dividends.
Scotiabank (TSX: BNS)(NYSE: BNS) is well-placed to optimize its high-growth banking. It has a solid financial position and improved efficiency. Its role is going to improve its profitability. Scotiabank (see also bank ETFs and ETFs by other sectors) has been paying dividends regularly too. Its stock is undervalued.
Kinross Gold (TSX: K) is presently a cheap stock. It is trading more inexpensively than its competitors as well, but its stock will look bullish shortly. Kinross has a solid financial position. Its balance sheet is strong and has a steady cash flow evident from the dividend yields and repurchase of shares that they have been doing. In addition, while the silver market has been lackluster recently, our best silver stocks review shows how taking advantage of this industry could be great option.
Enbridge (TSX: ENB)(NYSE: ENB) is yet another undervalued stock. It has revamped its business momentum and diversified its assets which indicates a steady cash flow. Its dividend share percentage is 6.6% which is relatively high and a testimony that it is undervalued.
The Bottom Line
There are several ways of evaluating different company metrics to determine the value of their stocks. Focusing on a business model is relevant to assess its value as all metrics will fall back to their goals and operations. When you set out to buy stocks, take time to make an informed decision by considering the above metrics.