If traders can find a stock trading at a price that is lower than its “fair” value (undervalued), they may be able to profit. Here are eight strategies to identify inexpensive stocks and explain how to trade them.
What exactly are undervalued stocks?
A stock that is undervalued has a price that is lower than its true – ‘fair’ – value. Stocks can be undervalued for a variety of reasons, including the company’s recognizability, negative news, and market crashes. A core premise of fundamental analysis is that market prices will eventually adjust to reflect an asset’s “fair” worth, offering profit opportunities.
Finding undervalued stocks is more than just looking for cheap stocks. The goal is to seek out quality stocks at prices below their fair value rather than worthless stocks at extremely low costs. The difference is that good quality equity will appreciate in value over time. Many traders and investors want to emulate Warren Buffett’s strategy, which has always been about buying inexpensive equities with long-term growth potential.
Remember to always acquire accurate financial information on a stock you want to trade before making a decision based solely on your personal feelings.
Why are stocks undervalued?
Stocks fall in value for a variety of causes, including:
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- Market changes: market crashes or corrections may cause stock values to fall.
- Stocks might become undervalued as a result of negative press or economic, political, and societal upheavals.
- Cyclical fluctuations: Some industries’ equities perform poorly in certain quarters, causing share prices to fall.
- Miscalculated results: When equities do not perform as expected, the price can fall.
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How do investors locate undervalued stocks?
Traders employ fundamental and technical research to identify undervalued stocks. Fundamental analysis is a way of determining an asset’s value through researching external events and effects, as well as financial statements and industry trends. Technical analysis is the use of historical charts and statistics to examine and anticipate price changes.
Eight methods for locating undervalued stocks
There are eight ratios typically employed by traders and investors as part of fundamental analysis. The following ratios could be used to identify and determine the true value of undervalued stocks:
- P/E ratio (price-to-earnings ratio)
- Debt-to-equity (D/E) ratio
- Return on investment (ROE)
- Earnings per share
- Dividend income
- The current ratio
- The price-earnings-growth ratio (PEG)
- Price-to-book (P/B) ratio
Each of these ratios is examined in depth in the section that follows. Remember that a ‘good’ ratio will differ depending on the industry or sector, as they all face various competitive challenges.
P/E ratio (price-to-earnings ratio)
The most common approach to assess a company’s worth is through its P/E ratio. In essence, it displays how much money you’d have to spend to make one Swiss franc. A low P/E ratio may indicate that the equities are cheap. Divide the price per share by the earnings per share to get the P/E ratio. Earnings per share are computed by dividing the overall profit of the company by the number of shares issued.
Example of a P/E ratio: You purchase ABC shares at CHF 50 per share, and ABC has 10 million shares in circulation and a profit of CHF 100 million. This translates to CHF 10 per share (CHF 100 million/10 million) and a P/E ratio of 5 (CHF 50/CHF 10). As a result, you’ll need to invest CHF 5 for every CHF 1 profit.
Debt-to-equity (D/E) ratio
The D/E ratio compares a company’s debt to its assets. A greater ratio may indicate that the firm derives the majority of its money from lending rather than its shareholders; nevertheless, this does not necessarily imply that the stock is undervalued. To do so, a company’s D/E ratio should always be compared to the average of its competitors. This is because a ‘good’ or ‘poor’ ratio is determined by the industry. Divide liabilities by stockholder equity to get the D/E ratio.
Example of D/E ratio: ABC has CHF 1 billion in debt (liabilities) and CHF 500 million in stockholder equity. The D/E ratio would be 2 (Swiss francs 1 billion/Swiss francs 500 million). This indicates that for every CHF 1 of equity, there is CHF 2 of debt.
Return on equity (ROE)
ROE is a ratio that compares a company’s profitability to its equity. Divide net income by shareholder equity to calculate ROE. A high ROE may indicate that the stock is undervalued because the company generates a lot of money in relation to the amount of shareholder investment.
ROE: ABC has a net income of CHF 90 million (income minus liabilities) and stockholder equity of CHF 500 million. As a result, the ROE is 18% (CHF 90 million/CHF 500 million).
Earnings per share
The earnings yield can be thought of as the inverse of the P/E ratio. It is earnings per share divided by the price rather than earnings per share divided by the price. Some traders believe a business is undervalued if its earnings yield is greater than the average interest rate paid by the US government when borrowing money (known as the treasury yield).
Example of earnings yield: ABC has earnings per share of CHF 10 and a share price of CHF 50. The profit yield will be 20% (CHF 10/CHF 50).
Dividend income
Dividend yield compares a company’s annual dividends – the fraction of earnings paid out to stockholders – to its share price. Divide the annual dividend by the current share price to get the percentage. Traders and investors prefer companies with high dividend yields since they may indicate greater stability and earnings.
Dividend yield example: ABC pays out CHF 5 per share in dividends every year. The current share price is CHF 50, implying a 10% dividend yield (CHF 5/CHF 50).
The current ratio
The current ratio of a corporation measures its ability to pay off obligations. It is simply determined by dividing assets by liabilities. A current ratio of less than one indicates that the available assets are insufficient to satisfy the liabilities. The lower the current ratio, the more likely the stock price will continue to fall, even to the point of being undervalued.
ABC has assets worth CHF 1.2 billion and liabilities at CHF 1 billion, so the current ratio is 1.2 (CHF 1.2 billion/CHF 1 billion).
The price-earnings-to-growth ratio (PEG) compares the P/E ratio to the percentage growth in annual earnings per share. If a company has strong earnings and a low PEG ratio, its stock may be undervalued. Divide the P/E ratio by the percentage growth in annual earnings per share to get the PEG ratio.
ABC has a P/E ratio of 5 (price per share divided by earnings per share) and a 20% annual earnings growth rate. The PEG proportion would be 0.25 (5/20%).
Price-to-book (P/B) ratio
The P/B ratio compares the current market price to the company’s book value (assets minus liabilities, divided by the number of shares issued). Divide the market price per share by the book value per share to get the answer. If the P/B ratio is less than one, the stock may be cheap.
Example of P/B ratio: ABC’s shares are selling for CHF 50 a share, and its book value is CHF 70, resulting in a P/B ratio of 0.67 (CHF 50/CHF 70).
How to Invest in Undervalued Stocks
To trade inexpensive stocks, begin by reviewing the eight ratios listed above. The main goal is to locate shares with different ratios than the industry standards. Remember that, while these ratios are valuable, they should only be used as part of your overall study. This, in turn, should be paired with in-depth technical analysis to provide a comprehensive picture of the market.
After you’ve decided which stocks to trade, you can speculate on their prices using a CFD trading account. If you want to trade the stocks, you may open a position when the ratios stray from industry standards and close it when they return to the industry standard. If you decide to acquire the stocks, consider whether the ratios indicate a low purchase price.
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