The funny thing about business journalism and stock market financial news is the fact that almost every guest at those finance news say that they have found some amazing stock that is undervalued. It’s as if that word gets kicked around so much, so often, that it really doesn’t mean much of anything at all. I really can’t blame you if that’s the impression you get every time you hear the word “undervalued.”
Well, don’t get too cynical because it does have a specific meaning. An undervalued stock can lead to you making a lot of money off the stock market. It does exist. But unfortunately, finding it can be downright frustrating if you don’t know what to look for.
Complicating all of this is the fact that that term keeps getting used and we’re at the point that you can realistically say that a lot of people really don’t know what it means. This can be the kiss of death if you pick a stock thinking that it’s undervalued when it turns out it’s anything but.
So how do you tell if a stock truly is underappreciated by the market and can lead you to make quite a bit of money in the future? Well, pay attention to the following signs. They’re not slam dunks in and of themselves, but when you add them all up and you look for other contextual signals, this may indicate that the stock that you’re looking at is a bargain. You scoop it up now and later on you unload.
Of course, ideally, you should adopt Warren Buffet’s investing philosophy. Warren Buffet says that you should buy the company, not the stock. In other words, don’t look at whether there is undervaluation or not. Look at whether the company is worth buying or not.
This should be your ultimate benchmark, but if you just want to buy the stock and then unload it in about a year or two, this middle of the road valuation approach involving certain signals may be the best fit for your investment timeline and needs.
P/E is the Main Indicator of Valuation
Look at the price per earnings ratio of several stocks that you are trying to analyze. Generally speaking, price per earnings is the main indication of valuation. Usually, you can tell whether a stock is a good bargain or not. If its P/E ratio is very low, meaning, it has a very high earnings and its price doesn’t really reflect much of that earnings, you might have a bargain on your hands.
But this doesn’t necessarily mean that the market would agree with you. As I keep mentioning in this blog, stock market valuations ultimately are a popularity contest. Seriously. If you don’t believe me, do understand that there are a lot of other sound, tried and proven, money making companies other than Tesla Motors, but it seems that the stock market has fallen head over heels in love with Tesla. And these companies which make money quarter after quarter, year after year, decade after decade, are essentially treated like step children.
Now, don’t get me wrong, I’m not saying that their stock prices are not going up, but their stocks are not appreciating as fast as companies like Tesla. What gives?
So in this case, understand that even though these companies have a nice P/E ratio, that, in and of itself, doesn’t mean that the company’s stock price is poised for takeoff. They’re just not sexy enough for the stock market, I guess.
P/E can Be Distorted
Understand that while P/E is a good indicator of valuation, in and of itself, it may not be enough. You have to understand that sometimes P/E can be distorted due to a wide range of factors. This doesn’t mean that the company is messing around with the books. This doesn’t mean that they are pulling all sorts of shenanigans. It doesn’t have to mean any of that. There is just a distortion between market valuation and market sentiment and actual earnings. Also, even if a company is very popular right now, it can still be undervalued because it has something else going for it.
Your job, if you want to make good money spotting undervalued stocks and then unloading them the moment the rest of the stock market catches up to you, is that you should be on the lookout for other factors that lead to undervaluation. Again, P/E is a great place to start, but you shouldn’t stop there.
Look at Price to Book Value
One great place to look is book value. What assets do the company have? If you were to sum up all of its assets in whatever form they take and compare it to the stock price on a per share basis, do you see a favorable comparison? Is there a lot of book value for the price? This is a good indicator of a solid company. On the other hand, if it’s the other way around where you have a lot of price and not enough book value, then you can see that the company’s pricing is mostly air.
Look at Price to Cash Flow
Another factor you can look at is how much cash flow the company has. This is a big deal. Personally, I prefer this analysis because if you’re just going to look at earnings per share, it can be distorted because it may turn out that the company had to pay a fine this year. Well, if it paid a multi-million dollar fine, that’s going to cut into its earnings and it would seem like the company didn’t make as much money as before. Well, it’s a one time loss. That’s not really a good reflection of the company’s overall viability as well as the direction it’s going.
Similarly, if the company sold off a division and made a lot of cash this year, that one time gain may look good on paper and blow up its price per earnings ratio. But then you realize that this is just a one time thing and it might mask the overall weakness of the company. With cash flow, it’s harder to lie. With cash flow, it’s harder to walk away with a distorted view of the value of the company.
So if you see a positive cash flow that indicates that the company has many different customers and has a diversified base and it’s growing while its stock price is low, then you might have on your hands a solid company that’s undervalued. However, keep in mind that it has to be sexy enough for the stock market to catch up to it. This is the wildcard. You keep this unknown.
What Do You Do Once You Have an Undervalued Stock?
So after doing all the analysis above, what you do when you find an undervalued stock? Well, it’s actually quite simple. Be prepared to wait a long time. Seriously. There’s really no other way around it. What you’re doing is you’re waiting for the rest of the stock market to wise up to your decision.
The good news here is that the sooner you discover this undervalued stock, the sooner you lock in to a fairly low price. Once analysts start wising up to this stock, your profit margin erodes if you buy in at those points. But if you buy in early enough, you can stand to make quite a bit of money. So be ready to play the long game.
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