If you have ever turned on your TV during the beginning of a recession, or follow the latest financial news, you have probably heard of the phrase ‘undervalued stock’. For many, they have no idea what an undervalued stock even is, or even how to find an undervalued stock!
Even we have been guilty of using the phrase ‘undervalued stock’, without properly telling you how to find an undervalued stock, or what one even is!
An undervalued stock is a stock whose price does not reflect the true value of the stock.
Take for example, Company A, their stock is valued at $35 per share, with a market cap of $300 billion. However, they have been investing 25% of their profit, year on year, into their competitors, amassing a 5% share in all local competitors.
However, almost all of the stock information about the company fails to mention it, or is just missed entirely. This means, that you can calculate that each individual stock is worth $45 intrinsically, rather than the $35 it is listed at.
Essentially, you are paying $35 for a $45 return, without doing anything and without waiting. Essentailly, that is what an undervalued stock is: a stock that is worth less than it actually is.
Take this quote from Warren Buffett for example:
When you are trying to find an undervalued stock, you are essentially looking to pay fifty cents for a one dollar bill.
4 best ways to find an undervalued stock
There are quite a few ways to find stocks that are undervalued, but I have comprised a list of the 4, I personally use. These are all methods that I use regularly when I am deciding whether or not to invest in a company.
4. Look at the company’s stock holdings
For a lot of people, their main source of wealth is their investments, this is normally done through stocks and real estate. The same is true of corporations for that matter!
Whilst some companies may try to hide their stock holdings (whether for private or professional reasons), most tend to have their stock holdings on their website.
These can usually be found in one of two places: their annual report, or *one* of their press releases. Find one example, here on The Motley Fool for Softbank Group
When we are talking about their stock holdings, I am not talking about the stock that the company holds in itself, but the stocks the company holds in itself.
Take the aforementioned Motley Fool article, Softbank has significant holdings in Uber and ARM Holdings.
This means that you can see that they are trying to diversify themselves away from their main business (Ok, Softbank probably isn’t the best example as their whole business revolves around investing in other companies).
Instead of it being Softbank, it is Company B (the company you are looking to invest in). They are a cutting edge tech company looking to change watches forever.
Yes, we might have an Apple Watch, but they are focusing on making the watch holographic, like something out of Star Wars.
Company B currently holds stock in several large watch makers throughout the world, a micro-chip company, and a holographic-projector lens producing company.
This shows you that it is an undervalued company as they are trying to invest out of their industry. And, depending on the amount they have invested, divided by the amount of shares outstanding, you could possibly have made it so you can find an undervalued stock.
Finance Friday has no financial relationship with any of the parties stated above, it was merely the easiest example to visualize. Please, do not go rushing to buy Softbank because I mentioned them.
3. Use ratios
This is a great way to find an undervalued stock and, is far less time-consuming than finding the individual stock holdings of each company. (Not to say that looking at the individual stock holdings of a company isn’t worth the time, because it completely is).
Whilst there are many stock ratios that you can use, I tend to use only two (although, it is generally advised that you use as many has possible to make sure, 100% that the company is undervalued.
I tend to use: debt/asset ratio and price/book ratio.
Debt/asset ratio
This is probably one of the most useful methods to find an undervalued stock. Debt to asset ratio measures how much debt a company has compared to their assets.
The ideal ratio would be anything below 1 (although some claim that 1.1 is also a good ratio to have as well).
It is calculated by dividing the dollar value (USD) of the debt a company has, to the dollar value (USD) of its assets.
For example, If company C has $1,500,000 (USD) of debt and assets of $3,000,000 (USD), the debt/asset ratio is 0.5.
Price/book ratio
The price/book ratio measures the current stock price versus the book value of the stock.
Your ideal ratio would be anything below 1.
It is calculated by dividing the current share price by the book value of the stock.
For example, if Company C has a share price of $50 and a book value of $60, the price/book ratio is 0.83.
I would argue that the price/book ratio is the most important thing to check when your aim is to find an undervalued stock.
2. Lagging behind their competitors
“What? The whole point of investing is to make money, not waste it, right?” Yes, it is and this is what your fellow investors are also thinking.
They see that Company C’s share price is only $50, whereas, Company D and Company E have share prices that are in the $60-range. So, instead of investing the undervalued Company C, they invest in the overvalued Company D or E.
This forces the prices of Company D and E, way above their actual price, but leaves Company C to have an even lower share price.
This is what truly makes Company C undervalued, and well worth the money you will have to pay for it.
1. Wait until a recession or drop
This is the most important step when you find an undervalued stock: wait. Wait until the next recession, and then invest.
Imagine, you’ve found the best stock in terms of how undervalued it is, and then I say to you “If you wait two months, save up even more, you’ll get double the amount of shares!”
(This is assuming, somehow I know when the market is going to crash (which I currently don’t).
By waiting, you allow yourself to do two things: get way more shares and save up just a little bit more.
By waiting until the next recession, you allow yourself to find an undervalued stock, and then double the amount of stocks that you can get from it, from simply waiting.
You also allow yourself to save up even more, for when the crash happens. Both of these allow you to purchase way more stock than you had originally intended to get!
Have you ever been lucky enough to find an undervalued stock? What was it? What method(s) did you use to find an undervalued stock? Tell me in the comments!
