How to Indicate an Undervalued Stock
A stock that trades below its book value is an undervalued stock. Pioneered by author Ben Graham in the 1930s and championed by mutual fund manager Peter Lynch and legendary investor Warren Buffett, value investing is about finding stocks that are trading below what they are worth. According to a summary of value investing techniques by New York University professor Aswath Damodaran, the success factors include having a long time horizon and diversification. Undervaluation indicators include a low share price relative to earnings, sales and book value.
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Instructions
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Learn how to use free online resources for screening stocks. Yahoo! Finance lets you screen based on ranges, while FINVIZ.com allows you to find stocks based on multiple financial ratios, including trailing and forward price-to-earnings ratios. Yahoo! Finance also provides an industry summary page that lets you review up-to-date financial ratios of several industry sectors on a single page.
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Screen stocks based on the price-to-earnings ratio, which is the ratio of the current share price to the trailing 12-month earnings per share. Stocks that are trading at low price-to-earnings ratios relative to the industry average could represent attractive undervalued investments.
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Scan stocks based on the price-to-sales ratio, which is the ratio of the current share price to the trailing 12-month sales per share. Damodaran cites research to suggest that this ratio may be better suited at picking smaller firms.
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Find an undervalued stock based on the price-to-book ratio, which is the ratio of the current share price to the trailing 12-month book value per share. Book value is assets minus liabilities. Damodaran suggests that this ratio is a good undervaluation indicator because stocks with low price-to-book ratios outperform those with high price-to-book ratios and the overall market over the long term.
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Look for stocks that have sold off recently. Start with the list of biggest percent decliners published by major financial websites, including the Market Data Center section of "The Wall Street Journal" website. This investing technique relies on the fact that markets tend to reverse over the long term.
For example, investors who bought into the market corrections of October 1987, September 2001 and late 2008 saw their portfolios increase in value over the ensuing months. However, this is not always true -- as of August 2011, many stocks hit hard in the dot-com crash of 2000 have not recovered their values.
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Research the fundamentals before investing. These include earnings growth and low levels of debt relative to equity. Do not buy a stock just because its price has fallen sharply, because there might be a logical reason for the price decline.
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