If you're new here, you may want to subscribe to my RSS feed. Thanks for visiting!

Value Investing is all about finding stocks that are priced at below their intrinsic value. While many formulas such as a discounted cash flow try to pinpoint the exact intrinsic value of a particular stock, but as many value investors like to point out, you want to get an idea of intrinsic value not an exact figure. For example, instead of saying ABC company is should be valued at $20 per share, one can use a set of assumptions in the  discount rate and growth rate to arrive at a range. We then might say that ABC company is worth between $18-$25. 

Who are undervalued stocks for….

Surprisingly, not all investors, both institutional or retail, focus on finding on finding undervalued stocks. Some individuals rely on momentum indicators such as volume to make their buy and sell decisions. In addition, technology over the past decade has created some spectacular software for day traders by making day trading seem like a video game.  On occasion, some  individuals who move in and out of stocks might make money, but taxes and trading fees make it difficult for trades to consistently beat the market indexes over the long haul. On the other hand, using patience, holding individual stocks for over a year, doing proper security analysis, keeps your fees and taxes lower and increases the odds of outperforming market indexes over the long haul. So for the most part, undervalued stocks is generally for individuals who are willing and able to hold for the long term, or at least 1 year.  But as Warren Buffett once said, “Value Investing is simple but not easy”, due in large part to investors getting caught up in the daily/minute movements of the markets.

Your typical undervalued stock…..

From personal experience, undervalued stocks have several characteristics that might give you a hint of whether they truly are undervalued. First they have low valuation multiples with the infamous P/E being the most popular. Generally, a low P/E indicates a stocks is valued or undervalued but definitely not undervalued. But caution, in cyclical industries such as housing and commodity , a low P/E might indicates that industry is peaking as cyclical stocks at their peak generally have a low P/E. You might want to take a look at housing stocks during the real estate bubble that occurred at the turn of the century, you will notice a similar theme. This happens due in large part to record earnings during peak times. When the economy turns sour, these cyclical stocks generally have no or little earnings which in turn results into high P/E”s which believe it or not might indicate a time to buy. Anyway, undervalued stocks tend to have low valuation multiples. Among them are low

• Price/Book-Value
• Price/Cash Flow
• Price/Dividend

Also, undervalued stocks tend to have something wrong with them in the short term. Thus, it is important for one to very patient and careful as to not fall in to value traps. In my opinion, patience is the biggie. Again, in general, undervalued stocks generally have some short term wounds. The keyword being short term. Put simply, investors  are not willing to wait until short term wounds are gone, Its tough, but people forget when they buy stock in the company, they are making an investment and investments due take time to develop. What types of companies do you want to look at and are ideal? First, look at their financials. Consistent numbers across the board such as operating ratios, profitability,earnings, etc.. How about it being a simple business? Keep it simple stupid. Let’s not complicate our lives here. We are trying to make investing simple and avoid as many headaches as possible. Also, look at the amount of debt the company currently carries on its books.  Especially if its a short term problem, you want to make sure the company does not go belly up while it fixes those issues. The funny this is, sometimes there is nothing wrong with a company and its selling at a discount to intrinsic value. This usually happens due to analyst basically dumping stocks to an extreme level if  stocks due not meet their expectations. These expectations could be several factors such sales growth, earnings growth or cost cutting efforts.

Where to find undervalued stocks…?

In other words, where to fish.  The most common place to look is the 52 week low list which could be found on multiple websites such as Morningstar.com To do this, simply take note of the stocks hitting new lows and do simple analysis as to why the stock is hitting new lows. Most of the time, they will be some companies with serious fundamental issues, but sometimes a gem, comes along.

Value Screens- With the invent of the internet, value screens have become popular. They are available on just about every website. Also, certain sites have created their own pre defines screens which are intended to find certain stocks such as “Growth At A Reasonal Rate (GARP)

Finally, the other place to look for undervalued stocks is good ol hard work. A simple system that I use every once in a while is to take a financial newspaper like the Journal and take not of companies mentioned. At the end of the day, you should have a nice list of companies in which you can learn something about. I would start off with whether you understand the business, the amount of debt the company has on its balance sheet and use some sort of valuation method to get an idea of the company’s fair value. It’s OK to pass up on stocks. Not every stock you come across will be undervalued or will meet your criteria. Some stocks will make no sense at all, while others will be great companies but will not be undervalued.

A final piece of advice on undervalued stocks.  An undervalued stock should scream out buy. I used to rely on a discounted cash flow model to determine whether a stock is a buy or not. I have an Excel sheet in which I could enter a ticker symbol and a discounted cash flow model is automatically generated. While this approach works, I have found that stocks that automatically scream buy are the most successful. These undervalued stocks come around once in a blue moon and when you find them  load up.

Update: After I wrote this article, I followed it up with Undervalued Stocks March 2010

Related posts:

1. How to Determine A Company’s Stock Is Undervalued
2. Looking For The Best Undervalued Stocks
3. Undervalued Stocks Near A 52 Week Low
4. What happens when a stock is extremely undervalued?
5. Undervalued Stocks March 2010