If you’ve been investing in stocks for a while, you know making money from the stock market is plain sailing. The drill is basic - you buy a certain stock at a certain price and then sell it at a higher price. But when stock prices fall lower than the purchase price, what should you do? And how do you recognise the right price to buy stocks? These are the questions that investors are often puzzled by. But one approach, dating back at least to Benjamin Graham’s 1949 book, The Intelligent Investor, can help you find the “best” investments based on your time frame, risk tolerance and specific objectives. It involves identifying “undervalued stocks” that for one reason or another are selling at prices far below their underlying values.
The underdogs of the stock market
A number of times, certain not-so-popular companies show growth in sales and profits quarter by quarter but their stock prices don’t go up. These companies go unnoticed by traders and investors alike and so their stocks are available at cheaper prices in spite of their demonstrated growth. So, if a company has grown in profit by 20% in the last three quarters but the stock price has not risen at all or has just increased by 1-10%, it is an undervalued stock. Often, the price of such stocks catch up with the profit and sales growth of the company ultimately. Over time, those who recognised this undervalued stock and invested in it would make financial gain for sure.
Undervalued stock indicators
The idea is to identify undervalued stocks before anyone else does because once they gain attention, their prices are bound to go up. There are six criteria investors can look for while spotting an undervalued stock:
Low Price/Earnings (P/E) ratio: The P/E ratio is calculated as a stock’s current share price divided by its earnings per share (EPS) for a 12-month period. A stock trading at Rs 40 per share with an EPS of Rs 2 has a P/E ratio of 20, while a stock trading at Rs 40 per share with an EPS of Re 1 has a P/E ratio of 40, meaning the investor pays Rs 40 to claim Re 1 in earnings. An undervalued stock will usually have a lower PE ratio.
Lagging relative price-performance: A company’s share price could be lower than that of its industry peers for several reasons. One of them is when a financial expert shows concern over certain financial metrics and the whiplash causes investors to sell-off and drive the price down. The price is sometimes driven so low that the stock becomes undervalued. You could check your screener for an option that lets you compare individual stock price histories over different periods of time against other individual stocks and stock indexes.
Low price/earnings growth (PEG) ratio: Considered more accurate than just a company’s P/E alone, PEG is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS) and the company's expected growth. It is calculated by taking the P/E ratio and dividing it by the ‘earning growth rate.’ If the ratio is less than 1 (e.g., a P/E of 10 and projected growth of 15%, giving us a PEG ratio of 0.66), investors may be giving more weight to past performance rather than future growth opportunities. However, be aware that growth projections are just that - projections.
High dividend yield: Something that most investors choose to ignore - if a company’s dividend payment rate exceeds that of their competitors, it may indicate that the share price has dipped to “undervalued” status (in relation to its dividend payment). Consider if the company is not financially unsettled and future dividend payments appear secure, the dividend opportunity can provide returns in the short term as well as potential for the stock price to move higher in the future. If you’re using a stock screener (see below), use the “dividend yield %” to find undervalued stocks in a given industry.
Low market-to-book ratio: The Market to Book ratio (also called the Price to Book ratio), is a financial valuation metric used to evaluate a company’s current market value relative to its book value. The market value is the current stock price of all outstanding shares (i.e. the price that the market believes the company is worth). The book value is the amount that would be left if the company liquidated all of its assets and repaid all of its liabilities. A company that has a low market value as a ratio to book value may present an undervaluation situation. The key is understanding the real value of both tangible assets (land, buildings, cash) and intangible assets (goodwill, intellectual property). For example, a company that produces and sells tea might also own property. The value of the property the company owns could potentially be worth more than the tea business it operates. Investors might overlook this and the price of a stock will not reflect the underlying value of assets the tea company has on the books.
However, do keep in mind that these metrics are not all chief factors that determine if a stock is a good value. A single measure can not be applied by an investor to ensure if a potential investment is undervalued. If more than one of these seem to be true for a stock, you may have located a market inefficiency that is a good investment opportunity.
