The ultimate look at how to find undervalued stocks
Fundamentals 16: To find undervalued stocks, you compare price with value. This article looks at how to value companies and what to consider when comparing price with value.
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| "I don't look to jump over seven-foot bars; I look around for one-foot bars that I can step over." Warren Buffett |
If you are going to spend time and effort to find undervalued stocks, there must be some benefits from doing so.
If you are a fundamental investor, you buy undervalued stocks as you believe that the market has misrated them. When the market re-rates them, you can make money.
It is obvious that if you invest based on technical analysis or if you index, there is no benefit in looking for undervalued stocks.
There are two aspects to the question of how to find undervalued stocks:
- How to determine that a stock is undervalued?
- How to find such stocks?
In practice, there are 2 main ways to determine whether a stock is undervalued. First, you can compare its price with its intrinsic value. Secondly, you can use multiples to compare its performance relative to some peers.
But finding undervalued stocks alone is not enough as stocks could be undervalued for good reasons. You also want to avoid value traps.
Finally, you must know where to hunt for such stocks.
I am a long-term value investor. The majority of my investing time is spent looking for undervalued stocks. In this post, I will share how I value stocks and what I do to find them.
Contents
1. Why look for undervalued stocks?
2. How to determine whether a stock is under or overvalued?
3. Why do stocks become undervalued?
4. How to use relative valuation to find undervalued stocks.
5. How to use intrinsic valuation to find undervalued stocks.
6. How to use the Magic Formula to find undervalued stocks.
7. How to avoid value traps.
8. How to carry out a company analysis.
9. How to find undervalued stocks.
10. Summary
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1. Why look for undervalued stocks?
There are 4 main ways to invest in the stock market:
- Based on technical. This is a market sentiment-driven approach where you buy popular stocks. You believe that this will drive prices up. Many use charts, trendlines, and other technical indicators to gauge market sentiments.
- Fundamental investing. You look for opportunities where the price is less than the value of the underlying business. These are stocks that are undervalued relative to the fundamentals. You believe that the market will eventually re-rate such stocks enabling you to make money.
- Factor investing. You invest in stocks based on certain characteristics eg growth or momentum that has been proven to explain stock returns.
- Indexing. You believe that the price reflects all known information about the stock. So, you cannot get any advantage. You buy the market.
It is obvious that you are only concerned with looking for undervalued stocks if you are a fundamental investor. If you are following the other investing styles, finding undervalued stocks is not important.
2. How to determine whether a stock is under or overvalued?
“Undervalued is a financial term referring to a security or other type of investment that is selling in the market for a price presumed to be below the investment's true intrinsic value. An undervalued stock can be evaluated by looking at the underlying company's financial statements and analyzing its fundamentals…to estimate the stock's intrinsic value…In contrast, a stock deemed overvalued is said to be priced in the market higher than its perceived value.” Investopedia
In the context of investing, under or over-valuation is the result of comparing the market price with some value of the stock.
There are 3 main ways to determine the value of a stock. The chart below illustrates this in comparison with valuing a house.
2.1 Relative valuation
In Relative valuation, you compare a company's value to that of its benchmark to assess the firm's financial worth.
Relative valuation uses multiples or ratios to determine a firm's value. To undertake a relative valuation, you must first identify the benchmark. This could be industry peers or businesses with similar prospects and risks.
You must control for the differences among the companies. One way is to scale the performance by earnings or size. That is why relative valuation usually involves some multiples. The more common multiples used are Price to Earnings, Price to Book, and Price to Sales.
There are two other ways that I have used relative valuation:
- Compared current performance with its historical performance. A relatively lower multiple compared to a historical one could point to undervaluation.
- Compared with some benchmark numbers. For example, I would consider a stock cheap if the PE is less than 10. A stock with a PBV of less than 1 would be considered cheap.
2.2 Intrinsic value
The Asset-based and Earnings-based valuation methods are known as absolute methods. This is because they make no external reference to a benchmark or average. For example, a company's Book Value which is expressed as a plain dollar amount tells you little about its relative value.
Absolute valuation models are alternatives to Relative valuation models.
The Asset-based and Earnings-based values are also referred to as intrinsic values. Purists will say that intrinsic value is the future free cash flows discounted to their present value. In other words, an Earnings-based valuation.
I don’t think there is any benefit in getting into this debate. Valuation techniques can be complex. There are many who can point to links between Asset-based values with Earnings-based ones.
All valuation involves assumptions and so different approaches will provide different answers. I use both the Asset-based and Earnings-based methods to triangulate the intrinsic value.
2.3. Asset-based valuation
Asset-based valuation focuses on the value of the company’s assets. There are several components of the Asset-value.
- Liquidation Value - this is the value if the company is no longer an “ongoing concern”. The Graham Net Net is considered by many as a shorthand for finding the liquidation value of a company.
- Net Tangible Asset - this is the Book Value less all the intangibles.
- Book Value - this is the value of the company according to its books of accounts. It is what the shareholders would get if all the company assets are sold off and all the debts and obligations are paid off.
- RNAV - Revised Net Asset Value. In some cases, the assets in the books are carried at historical values. If these assets are revalued to the current market value, we then have the RNAV.
- Reproduction Value. This is the value to re-produced the company with its customer relationships, production know-how, and other intangibles.
The chart below shows how the various components of the Asset-Value can be built up.
2.4 Earnings-based valuation
Many would consider the “correct” intrinsic value as the cash flow generated by the company over its life discounted to the present value. This is a DCF or discounted cash flow method.
There are 2 main ways to determine the intrinsic value of a company:
- The discounted cash flow method as per Damodaran.
- The residual income method as per Penman.
Both methods would give you the same answer if the assumptions used are consistent. In practice, I have found that because of the lack of information, it is very difficult to have consistent assumptions.
What I generally do is then take the average of both methods as the intrinsic value.
According to Damodaran, there are 4 parameters to consider to determine the intrinsic value of a company using the DCF method.
- The free cash flow.
- The duration of the high growth period.
- The discount.
- What happens at the end of the high growth period ie the terminal value.
I would not try to teach you how to use the discounted cash flow method to value a company as it is not something that you can cover in one post. MBA students spend a semester learning valuation.
For further valuation insights, refer to the following posts:
I used the values from the Damodaran and Penman methods to build up a picture of the Earnings-value as shown below.
2.5 Can you use technical analysis to find undervalued stocks?
To determine undervaluation, you compare price with value. As such you should not be using technical analysis to find undervalued stocks.
Technical analysis relies on price action and volume. It compares the price at one reference point with another point. Prices are not values.
Sure, use technical analysis to find momentum stocks or those favoured by the market. But do not confuse market sentiments with values.
3. Why do stocks become undervalued?
There are 2 main factors that affect a stock price.
- The business prospects ie fundamentals. In the long run, stock prices should reflect the business prospects.
- Market sentiments. In the short run, this has a bigger influence on stock prices than the business fundamentals. The challenge is that the business outlook also affects market sentiments.
Given the above interplay, there are times when stocks can become over or undervalued.
Thus the reasons why stocks are over or undervalued cover both market sentiments and business issues. Examples of why stocks are undervalued are:
- Market crashes or corrections could cause stock prices to drop.
- Stocks can become undervalued due to negative press, or economic, political, and social changes.
- Some industries are cyclical and the business may perform poorly over certain quarters.
- Misjudged results: when stocks don’t perform as predicted, the price can take a fall.
- The company’s fundamentals improve rapidly while the market price remains constant.
From an academic perspective, stocks are undervalued or overvalued because the market is not efficient.
The efficient market hypothesis states that share prices reflect all information. As such stocks always trade at their fair value on exchanges. This makes it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.
Therefore, those who looked for undervalued stocks believe that the market is not efficient.
4. How to use relative valuation to find undervalued stocks
When you use relative valuation, you compare the metrics of a given company with those of its peers. You determined if the metrics suggest that the value is in line with the peers, over or undervalued.
No single metric can ensure that a potential investment is undervalued. You are looking for a pattern of several metrics all pointing in the same direction.
There are a few metrics that are used in relative valuation.
- Price to earnings ratio (PE). The higher the PE, the higher the price of the stock relative to the earnings. While a low PE ratio may indicate a buying opportunity, it is important to dig further.
- Price earnings to growth ratio. (PEG). This is computed by dividing the PE by the “earnings growth rate.” If the ratio is less than 1, it may point to undervaluation.
- Price to book value. A low price to book may indicate undervaluation.
- Dividend yield. If a company's dividend payment rate exceeds that of its competitors, this may indicate that the share price is cheap.
- Price to Sales. This is one metric to use if you come across situations where the earnings are negative.
Relative valuation or multiples are rules of thumb and I would consider them as starting points. The other thing about using multiples is that the numerator and denominator must be consistent. For example, all the metrics mentioned above are based on the equity perspective.
I use relative valuation for screening by comparing a company metric with some absolute value. The absolute value is derived either from fundamentals or the market profile.
The charts below show the Bursa Malaysia profile that I used to derive the benchmark value.
Median PE = 9.8 for 2016 and 10.3 for 2021
Median PBV = 0.8 for 2016 and 2021
The example below shows how I use fundamentals to derive the benchmark value. Based on the Discounted Free Cash Flow to the Firm, we have
EPV = FCFF / discount rate
Given a no-growth scenario, FCFF = EPS
Assumed a discount rate of 10%.
EPV = EPS / 0.1
Equity + Debt = EPV
For a company without any debt, we have
Equity = EPS / 0.1
Thus PE = 10 for a debt-free company.
There are times when looking at equity-based multiples may not tell the whole picture. This is especially if a company is highly geared or if the equity has been reduced by share buybacks.
In such instances, it would be better to use firm-based multiples. So instead of PE, I use Enterprise Value to EBIT.
4.1 Acquirer’s Multiple
In his book, Deep Value, Tobias E. Carlisle defined the enterprise multiple or the Acquirer’s Multiple as
Acquirer’s Multiple = EV / EBITDA where
EV = Enterprise Value = Market Capitalization + Debt – Cash
EBITDA = Earnings Before Interest, Taxes and Depreciation & Amortization
Carlisle compared the returns using various valuation multiples. He found that the Acquirer’s Multiple had the most success identifying undervalued stocks. Wall Street’s favourite metric— price-to-forward earnings estimate—was by far the worst-performing ratio.
Because of this, I use the Acquirer’s Multiple as part of my valuation methodologies.
5. How to use intrinsic valuation to find undervalued stocks
I adapted Professor Bruce Greenwald's approach of comparing Asset value (AV) and Earnings value (EV) to gain strategic insights.
I also look at the margin of safety in the context of the AV and EV analysis with the following 4 scenarios:
Scenario 1: Excellent margin of safety. In this case, the market price is significantly below both the AV and EV. From a strategic perspective, the stock is earning a return reflective of the cost of capital as the AV = EV.
Scenario 2: Acceptable margin of safety. In this case, the market price is higher than the EV but lower than the AV. For the EV to be less the AV, it suggests that the company is not fully utilizing its assets. If you invest in a company under this scenario, it must be because you believe that the company would be able to turn around. And that in the worst-case scenario, the value of the assets would offer some protection if the business fails.
Scenario 3: Better than an acceptable margin of safety. The EV > AV suggests that the company has some competitive advantage. In this case, the market price is higher than the AV but lower than the EV. In this scenario, you believe that the company’s competitive edge would provide you with some margin of safety.
Scenario 4: Poor margin of safety: In this case, the market price exceeds both the AV and EV. The only rationale for investing in such a company is that you believe that the EV will increase over time. You believe that this is some growth company whose future value has yet to be captured in the current EV.
6. How to use the Magic Formula to find undervalued stocks
In “The Little Book That Beats the Market” Joel Greenblatt presented his “Magic Formula” for buying good companies at good prices. He focused on two key ratios:
Earnings Yield = EBIT / Enterprise Value
Return on Invested Capital = EBIT / Invested Capital
Where:
Enterprise Value is Market Value + Debt – Cash
Invested Capital is Net Working Capital + Net Fixed Assets
Earnings yield measures how cheap a company is compared to its ability to generate cash. All else being equal, you would want companies with higher earnings yields.
Return on Invested Capital measures how efficiently a company deploys capital. The higher, the better.
Greenblatt uses these metrics to ranks stocks and then select the top 20 to 30 stocks to invest. The Magic Formula was designed to help investors with “buying good companies, on average, at cheap prices, on average.”
I have adapted the Magic Formula concept to help triangulate the value of a stock.
7. How to avoid value traps.
You looked for undervalued stocks because you believe that they were mispriced by the market.
Finding undervalued stocks is not about finding ‘cheap stocks’ that remain useless. The idea is to find good stocks with the potential to perform well, but happen to be priced under their fair value.
However, this mispricing is only true if your assessment of the intrinsic value is correct. If you had assessed the value wrongly, then the stock is not undervalued. It is a value trap.
A value trap then is a stock that while appearing cheap, is actually cheap for a reason. The trap springs when the reason for why the stock is trading at a low price becomes evident.
To benefit from mispricing with undervalued stocks, you have to avoid value traps.
The best way to avoid a value trap is to undertake a fundamental analysis of the company prior to the valuation. The analysis will assess the prospects of the company, its risk, its business model, and track record.
The assessment will enable you to judge whether the problems faced by a company is a temporary one that can be overcome. At the same time, it will ensure that the assumptions you use in the valuation are grounded in reality.
You can conclude that a company is not a value trap if
- There is a sufficient margin of safety to a conservatively estimated intrinsic value. I normally target at least a 30% margin of safety.
- The assumptions are derived from both a qualitative and quantitative company analysis.
- The company analysis shows that the issues faced by the company are not insurmountable.
I have many case studies in the blog to illustrate what I look for in the company analysis. Refer to the following posts:
I would add that if you have used relative valuation to look for undervalued stocks, you should pay more attention to the company analysis. This is because the peers could all be overvalued. If so, then any relatively undervalued stocks may not be actually undervalued.
8. How to carry out a company analysis
The main goal of company analysis in the context of investing is to assess the prospects of the company. You want to ensure that when you value it, the assumptions you use are grounded in reality.
An in-depth analysis will require a review of key documents. These are usually the company Annual Reports, Financial Statements, and Industry Reports. Some people also do fieldwork by talking to competitors, suppliers, and key customers to get insights into the business. The objective is of course to get a good understanding of the business.
You look at the following:
- How the company got to where it is today from a qualitative and quantitative perspective.
- Whether management has done a good job.
- The business direction of the company.
While the focus is not valuation, I also looked at related valuation issues such as:
- Will there be Spectacular Growth in Shareholders’ Value?
- How to Secure Your Investment by Minimizing Risk.
I would not go into the specifics of what to look for as the case studies in my blog provide actual examples of these.
The above is a sort of qualitative analysis. When it comes to quantitative analysis, there are 2 areas to look for - performance and risk.
My top 3 performance metrics are:
- Returns as measured by Return on equity (ROE) and EBIT/TCE.
- Gross profitability.
- Growth. I look for positive revenue and profit growth trends over the past 12 years.
I looked at some metrics to gauge risks.
- Financial risks. I looked for total debt to be less than book value and for the Current ratio to be greater than two.
- Quality of earnings. I looked at accruals and the intensity of core earnings (ICE).
- Financial Scores developed by academics. I use Altzman Z Score, Piotroski F Score, and Beneish M Score.
For details on the various indicators, refer to the Definitions post.
9. How to find undervalued stocks
I suggest a 4 steps process to find undervalued stocks:
- Screening
- Company analysis
- Valuation
- Value trap check
9.1 How to screen for undervalued stocks?
Company analysis and valuation are time-consuming. You have to go through companies’ financial reports and industry reports for the information you need. You need to develop the financial model to value companies.
You don’t want to go through this process only to find that either the business prospects are not that good or that the company is highly overvalued. One way to avoid this is to screen the companies to weed out those with poor business fundamentals and/or likely to be overvalued.
I normally use financial ratios and multiples to screen for companies. I use the following metrics to weed out the weak companies. Those that do not meet these criteria are screened out.
- ROE > 10 %.
- Positive growth rate.
- Debt Equity ratio < 1.0.
- Current ratio > 2.0.
To improve the chances of finding value stocks, I hunt for them under the following circumstances:
- When the market is down.
- When a company has announced a loss.
- When a company cuts its dividends.
- When a company is emerging from bankruptcy.
- When no analyst is following the company.
Several of my undervalued companies are those that have a complex business structure or are in cyclical industries.
9.2 How to analyse for undervalued stocks?
There are many ways to analyse a company.
As a retail investor, you should not analyse it as if you are running the business. You are in no position to change the business direction or management. You cannot decide on its production or marketing strategy.
You can only assess the business as it is and project where it is heading based on its current strategy. Along this line, I analyse companies in the context of my investment thesis.
- For a compounder, I looked to see whether the competitive edge can be sustained.
- For a turnaround, I assessed whether it had the track record and management to turn it around.
- For a Grahan Net Net, I looked to see it has cost control plans.
- For a Quality Value company, I wanted to see that it can continue to improve its operations.
I valued companies using the Discounted Cash Flow and Residual Income methods. This required assumptions about the cash flow, growth prospects, and risks. A significant part of the company analysis is to ensure that the assumptions made are realistic.
9.3 How to value companies?
The key objective of valuation is to determine the intrinsic value so that I can use it to compare with the market price.
Unfortunately, all valuations are not only based on assumptions but are likely to reflect the many behavioural biases. You should address these two issues.
In order to mitigate against the behavioural biases, I do the following:
- Have a standard valuation model.
- Document the valuation process.
To address the assumption challenge, I triangulate the value using the following approaches:
- Intrinsic value. This is the average value derived from the Free Cash Flow to the Firm Model (as per Damodaran) and the Residual Income Method (as per Penman).
- Acquirer’s Multiple.
- Magic Formula.
I would assess that a stock is undervalued if all the 3 approaches point to undervaluation.
For those mathematically inclined, I look for a situation where all the above 3 metrics have about the same %.
- For the intrinsic value, I computed the % margin of safety.
- I inverted the Acquirer’s Multiple to get a %. For example, a multiple of 5 is equal to 20 %.
- I added both the ratios expressed in % in the Magic Formula to get the overall %.
9.4 How to check for value traps?
If the stock price is less than the intrinsic value derived from a DCF method, I would generally conclude that it is not a value trap.
This is because the intrinsic value has been derived based on conservative assumptions. And these would be after undertaking a comprehensive company analysis.
Furthermore, it would not be a value trap if it can deliver the required performance. This is the performance in the context of the investment thesis eg compounders or turnaround, etc.
10. Summary
I propose a 4-steps process to find undervalued stocks:
- Screening
- Company analysis
- Valuation
- Value trap check
The aim of screening is to avoid wasting time analyzing and valuing the wrong stocks. I used relative valuation for my screen. Once you have identified the potential stocks, I would undertake the company analysis.
I would go through the company’s Annual Reports, Industry Reports, and competitors Annual Reports. This is to assess the business prospects and risks. These helped me to ensure that the assumptions I used in my valuation are grounded in reality.
To value stocks, I use both the Asset-based and Earnings-based methods. I then assess whether the stock is undervalued using a number of methods. These are the Discounted Free Cash Flow, Residual Income, Acquirer’s Multiple, and Magic Formula.
Finally, I checked to see that the stock is not a value trap. A large margin of safety between the price and the intrinsic value derived assuming zero growth is one good indicator that it is not a value trap.
You will realize that to look for undervalued stocks, you have to analyze and value companies.
You may think that it is very challenging to do so. One way out is to then rely on third parties to do the fundamental analysis for you.
There are several financial advisers who provide such analyses.
Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.
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I am not an investment adviser, security analyst, or stockbroker. The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies. Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them.
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