How To Find Undervalued Stocks And Is It Possible At All?

How To Find Undervalued Stocks And Is It Possible At All?

The rapid rise of online trading has seen billions of dollars in capital rush head first into the stock market every year. From major institutions to individual investors, the stock market has something for everyone these days. However, this easy access has also come with one major downside - valuation. 

As a rule of thumb, investors look for undervalued stocks to purchase and wait until the financial results of the underlying company show growth, which in turn increases the demand for that stock and the price moves upward. This has been the case ever since the first stock markets emerged around the world. 

Nearly unmitigated access to financial investing has seen more capital enter the market than it is always able to handle, which leads to massive overvaluations of companies that do not yet have the operational means to catch up to that valuation. This has become a major issue for newcomers to the stock market, as some stock fundamentals do not seem to be effective in analyses anymore. 

Is this really true and is it impossible to find undervalued stocks on today’s stock market? Let’s find out. 

How Stock Valuations Work

Stock valuations are calculations that aim to determine the “actual” value of a stock. The stock market can be a highly irrational place at the best of times, with investors following their emotions more than pure reason, which can lead to stocks becoming overbought or oversold, which presents opportunities for market participants and makes the stock market so vibrant and diverse. 

The goal of stock valuation is to estimate what a rational investor should be willing to pay for a share of the company's stock. There are several methods used to value stocks, each with its own assumptions and limitations. Here are some common methods:

  • Discounted cash flow (DCF) analysis - This method involves estimating future cash flows based on past cash flows and an average growth rate for future fiscal years. This is done by discounting future values back to the present using a discount rate. The discount rate accounts for the time value of money and the risk associated with the investment. DCF analysis requires careful estimation of future cash flows and an appropriate discount rate
  • Price/Earnings (P/E) ratio - The P/E ratio is one of the simplest and most widely used valuation methods. It compares a company's stock price to its earnings per share (EPS). A higher P/E ratio might indicate that investors are willing to pay more for each unit of earnings, potentially reflecting higher growth expectations. However, it is important to consider growth prospects when using the P/E ratio, as well as industry norms 
  • Price/Book (P/B) ratio - This ratio compares a company's stock price to its book value per share, which is the net asset value of the company's assets minus liabilities. A P/B ratio below 1 might suggest that the stock is undervalued, as investors are paying less for the company's net assets
  • Dividend discount model (DDM) - DDM is used to value dividend-paying stocks. It calculates the present value of expected future dividends, considering the dividend growth rate and discount rate. The model assumes that dividends will continue to be paid and grow at a certain rate indefinitely
  • Comparable company analysis - In this method, a company’s value is determined by comparing it to a similar company from the same industry. The P/E and P/B ratios are often used in the comparison 
  • Enterprise Value/EBITDA (EV/EBITDA) ratio - This ratio compares a company's enterprise value (market capitalization plus debt minus cash) to its EBITDA (earnings before interest, taxes, depreciation, and amortization). It's particularly useful for valuing companies with varying levels of debt and depreciation

There are various methods of stock valuation available and the effectiveness of each may depend on several company-related factors, such as profitability, dividend payments, growth, assets, etc. 

The Warren Buffett Approach To Value Investing

Warren Buffett, the legendary investor, is a famous proponent of value investing, which involves the identification of undervalued companies with a competitive edge and buying heavily into their stock. 

This has been a theme throughout Buffett’s investing career, building up massive equity positions in the likes of Apple, Microsoft, and Bank of America over the past few decades. 

Buffett looks for a few important factors to identify a potential buying opportunity on the market, such as:

  • Intrinsic value using the DCF method
  • Quality of the company’s top management, their experience, and qualifications 
  • The economic moat in terms of cash reserves and the ability to consistently generate cash 
  • Straightforward and streamlined business model that is easy to understand 

This way Buffett has managed to avoid companies with highly speculative business models and stick to ones where he can understand the small details and intricacies of how things are done. 

Investing this way requires a good knowledge of accounting and finance to accurately identify the strengths and weaknesses of the company you are considering investing in. 

Finding Undervalued Stocks - Factors To Consider

Since the stock market is home to thousands of stocks from a variety of industries, finding an undervalued stock can be exceedingly difficult. However, there are a few key considerations to remember when it comes to filtering your search and finding the right fit with decent growth potential and solid financial standing. 

Do Not Avoid Tech Stocks

When investors think of overvalued stocks, they often picture a tech startup with a lot of hype behind it, which leads to the stock trading miles above its actual book value. This can lead to investors completely disregarding the tech sector when looking for undervalued stocks. 

However, this is not entirely accurate. While it may be true that a vast majority of tech stocks are highly overvalued and are the first to fall during recessions, the same recessions can bring them much closer to their book values than they would have been otherwise. 

This is an amazing opportunity for investors, as most of the investing public is aware that truly successful tech stocks will always be overvalued to a certain extent, but a tech stock that has been hit with a major broad-market sell-off can prove to be a gold mine. 

As an example, let’s consider the stock of Upstart Holdings (NASDAQ:UPST). Over the past year, UPST has been trading within the $12-14 range, which is a far cry from its all-time high in 2021, which saw the stock soar above a whopping $400 per share. 

At $12 per share, Upstart’s market cap was close to $1 billion, which, for a tech company with at least $500 million in annual revenues and significant growth potential, can be considered to be undervalued. 

The AI bull run came just in time for the stock and its shareholders, which shot up above $70 within just 2 months. 

Find Distressed Companies 

In some cases, distressed companies can be solid choices for undervalued stocks. When a company comes under financial distress or files for bankruptcy protection, investors are likely to sell the stock at unprecedented rates. 

As long as the stock remains listed on a major exchange and the management has a decent strategy for turning things around, distressed assets can be a blessing in disguise for investors with a high-risk tolerance and the capital to back them up.

Restructuring can reignite the interest of the investing community in a stock. A great example of this can be found when looking at the stock of United States Steel, which is one of the oldest public companies in the United States. 

U.S Steel, ticker X, dropped below $6 during the peak pandemic year of 2020, which valued the stock’s market capitalization at around $1.5 billion. The company, which had failed to recover from the Great Financial Crisis of 2008, has gained massively over the past two years - reaching over $30 per share. 

This growth can be attributed to rising steel prices, as well as the company’s defined vision to reclaim lost market share and reinvest into its physical assets. 

Key Takeaways From How To Find Undervalued Stocks

  • Finding undervalued stocks has become increasingly difficult in a globally interconnected stock market 
  • Most companies trade far above their book value, which limits the growth potential for new investors 
  • Valuation methods, such as discounted cash flows and dividend discount models, can help investors value the intrinsic value of a stock 
  • Warren Buffett has been a great proponent of value investing and chooses companies that have a competitive advantage and have competent and motivated management, as well as a streamlined business model 
  • Some tech companies, such as Upstart Holdings, have grown massively after depressed valuations 
  • Distressed companies with turnaround plans, such as the United States Steel Corporation, can also be viable candidates for value investors 

FAQs On Undervalued Stocks

When is a stock undervalued?

A stock is considered undervalued when the price of a share is trading below its intrinsic value. Investors and analysts calculate the intrinsic value using a variety of different methods, such as discounted cash flows, dividend discount models, etc. 

Are undervalued stocks risky?

There is a distinction between cheap and undervalued stock. Cheap stocks may be cheap for very solid reasons, such as bad financial performance, lack of growth prospects, etc. 

Undervalued stocks, however, represent a missed opportunity on the market that investors can capitalize on if they identify it as such. 

Are tech stocks undervalued?

Most tech stocks are profoundly overvalued. Tech is the most exciting industry on the market and attracts billions of dollars in investment, which makes it especially difficult to fund an undervalued tech stock.