How to Find Undervalued Stocks: A Step-by-Step Guide

Synopsis:
This short article will show you how to find discounted stocks. It will also help you acquire fundamental analytical skills to uncover an exciting investing concept. Practical tactics to identify undervalued stocks will give you the confidence to select better stocks for your portfolio.

Consider this scenario:You're shopping for a garment, and you come across one that's 60% off than its regular price. Naturally, you'd be thrilled with the value you're getting.

Now, replace the garment with shares; The only difference is you won’t see any advertised sales of it and that the share price might rise or fall in the future compared to its current price.

Stocks that investors perceive to be trading below their actual worth are known as undervalued stocks They have the potential to rise in the future when the market eventually recognises a company's actual value.

The art lies in identifying the undervalued share from the list of shares available in the stock market. Using a mix of Quantitative and Qualitative Measures can help you find the potential undervalued stock.

Quantitative Analysis

Quantitative Analysis involves using mathematical and statistical techniques to analyse financial data. Some metrics you can check are:

Qualitative Analysis

Qualitative analysis in business subjectively assesses a company's value using non-quantifiable factors like management, industry trends, R&D, and labour relations. Some metrics you can check are:

Competitive Advantage (Economic Moat)

An economic moat is a company's distinct advantage over its competitors, allowing it to protect its market share and profitability. A comprehensive economic moat is challenging to mimic or duplicate (e.g., brand identity, patents) and thus creates an effective barrier against competition from other firms.

Management Quality

A company's management quality indicates how well its leaders make decisions, manage resources, and achieve goals.

"Stick to proven management with a lot of integrity, talent and passion. After some other mistakes, I learned to go into business only with people I like, trust, and admire"

One of the ways to do that is to start learning about a company’s management by gathering historical and current articles written about the top managers.

Look for evidence in four primary areas – honesty, passion, transparency, and competence.

Debt Levels

A company's debt ratio tells the leverage it uses by comparing total debt to total assets.

It is calculated by dividing total liabilities by assets, with higher debt ratios indicating higher degrees of debt financing.

Whether or not a debt ratio is "good" depends on the context, such as the company's industrial sector and the prevailing interest rate.

Industry Trends

Some industries experience favourable trends (rising demand, government support, new technologies) that boost companies' prospects, while others face challenges. Growing industries often provide fertile ground for finding undervalued stocks.

Finding Undervalued Stocks

Stock Screeners

There are various screeners available on the net. The power of stock screeners lies in setting specific criteria that align with your value investing philosophy. Some examples of filters could be as follows:

Low P/E ratios (relative to industry or historical averages)

Low P/B ratios (potentially less than 1) High dividend yields (with a caveat to check if the dividend is sustainable)

Strong free cash flow

Contrarian Investing

As the name suggests, thinking differently is against the herd or overlooked by the market. Contrarian opportunities might be found:

Out-of-favor industries or sectors.

Companies face temporary setbacks (lawsuits, product recalls, etc.).

Small-cap or lesser-known companies that receive less analyst coverage.

Bottom line

Finding undervalued stocks requires a combination of number crunching and understanding the bigger picture. Don't be afraid to look beyond the obvious; that's often where the hidden value lies. Remember, patience and a thorough analysis are your key allies in uncovering potential gems.