How to find undervalued stocks in 3 simple steps

HOW TO FIND UNDERVALUED STOCKS IN 3 SIMPLE STEPS

BY NICK KRAAKMAN

Investors generally underperform the market because they do not buy stocks that are healthy and cheap, but stocks which grab their attention.

The reason why this approach leads to sub-par returns is because stocks which are covered in the media and followed closely by the masses are less likely to be undervalued. In addition, if you invest in the stocks everyone else is investing in, your performance will be equal to theirs; average at best.

However, you can't really blame people for taking this approach, because analyzing thousands of publicly listed companies is a daunting task. Or is there an easy way to filter out the hidden gems? I would argue there is, and in this post I guide you through my simple three step process of finding healthy, undervalued stocks to invest in.



Step 1: Generate ideas

Goal: identify +-30 companies to analyze further



Finding stocks to analyze is something many investors struggle with, but it is really not that hard. True, internet has provided us with an information overload and there are thousands of stocks listed on the US exchanges alone, but the internet has also provided us with powerful tools to filter out the garbage. Using free online stock screeners is my preferred method of finding stock ideas, because it allows you to make an independent, rational selection which is not influenced by opinions and emotions of others.

Remember: although we are looking for undervalued stocks, a cheap valuation is of no use if the financial situation of the underlying company is terrible. Therefore, the first step is to determine when you consider a stock "garbage" and when you consider it a wonderful company.



"It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Warren Buffett


The basic criteria I always use in this stage are:

Return on Equity > 15%
Indicates high profitability and potentially a competitive advantage
Debt-to-Equity ratio < 0.5
Implies that the company does not heavily depend on outside capital to finance its growth
Current ratio > 2
Makes sure that the company is able to pay its short term obligations
It is tricky to filter on P/E, because P/E ratio's differ greatly per industry and thus you potentially exclude perfectly sound investment ideas. On top of that, P/E in itself does not say much about whether or not a company is undervalued with respect to its intrinsic value. For similar reasons I dislike filtering on EPS growth rate, because a solid company with 0% growth can still be an interesting buy if the price is right.

Sometimes I do add Dividend Yield > 1% as a criteria, because I like receiving a steady dividend income. Another criteria I sometimes filter on is Market Cap < 1 Billion, because smaller companies are generally less closely followed by analysts and therefore more likely to be mispriced. This theory is confirmed by Ibbotson Associates, who found that Small Cap stocks significantly outperformed Large Cap stocks over the past century.

Once you have determined your criteria, use any of the following free online stock screeners and try to end up with around 30 ideas:

Google Finance
My personal favorite. A completely free stock screener with an easy interface to filter out the good from the bad.

Yahoo Finance
Yahoo offers a basic online screener as well as an advanced Java based screener. Both are free.

Fool.com
The Motley Fool stock screener is unique, because you can filter based on how well the members of their CAPS community think the stocks will perform.

FINVIZ
A popular free stock screener which I haven't used myself, but it seems to offer all the features you might need.

CNBC
This free stock screener allows you to incorporate analyst estimates and interesting financial ratios, like asset turnover and quick ratio.

Alternatives

Of course using online stock screeners is merely a way to identify interesting stocks to analyze. Here are three alternative approaches you could follow:

Get fresh ideas from the amazing pre-defined stock screens created by Old School Value
Check GuruFocus to see what your favorite investors are buying. GuruFucus also offers several great and unique stock screeners.
Subscribe to a paid investment newsletter, like AAII or The Motley Fool. However, do not blindly trust what others recommend and always perform your own due diligence.
Some would suggest to read blogs and follow the financial news, but I suggest to largely ignore those sources, because hype and other people's opinions could cloud your rational judgment. If you use other creative methods to come up with stock ideas, please share your experiences with the rest in the comment section so we can all learn from it.



Step 2: Create a shortlist

Goal: reduce your 30 ideas to 3 (or less) wonderful companies

Step 2 - Create a Shortlist - How to Find Undervalued Stocks

Got your 30 ideas? Great! This means you have already filtered out most of the garbage. Now it is time to see which, if any, of these 30 stocks has the makings of an outperformer. In step one you ran a simple screening process, now you will have to dig a bit deeper to identify the true gems. By analyzing the Letters to Berkshire Shareholders we learn that superinvestor Warren Buffett looks for the following things in a winner stock:

Consistently high profitability
High and preferably increasing net margins are a great sign which indicate that a company is either becoming more efficient, or is able to increase its prices. This in turn should lead to a steadily increasing book value. Also, be sure to check whether the company is generating healthy levels of Free Cash Flow (FCF). If a company reports net profit but is unable to generate FCF, this could indicate earnings manipulation.
Low debt levels
Large amounts of debt pose a significant interest rate risk and lead to inflated ROE figures. Debt heavy companies get in trouble more easily when sales slow down or interest rates start to fluctuate. A long-term debt-to-equity ratio below 0.5 is preferable, as well as a current ratio above 2.
A sustainable competitive advantage
Here the analysis goes beyond numbers and financial ratios. Highly profitable businesses attract competitors, and increased competition generally leads to lower profits, except when a company possesses a sustainable competitive advantage. Something which cannot be easily copied. Examples include patents, trademarks, lock-in effects, economies of scale, and network effects. Look for these important signs.
Honest, competent, shareholder friendly management
Stock market genius Peter Lynch suggests to look for businesses any idiot can run, because sooner or later an idiot will run it. Nevertheless, solid management plays a key role in business success. Therefore, always Google the names of the key executives to find out who they are and what their track record is. Add "scandal", "fraud", and similar words to your search to find out if they have been involved in anything shady. Do the same for the company itself.  Also analyze the capital allocation strategy of the company. Use the following rule of thumb: a company with a consistently high return on equity and plenty of growth potential should reinvest (a big part of) its earnings into the company, else shareholders are better off if the company pays out a dividend and/or buys back shares. However, buying back shares should only be done when the stock trades significantly below the company's intrinsic value.
A business you understand
Buffett once said he and his business partner Charlie Munger stick to businesses they understand, and I suggest you do the same. Are complex companies less likely to outperform the market? Not per definition. However, the reason to avoid them is because the more complex a business is, the harder it becomes to make a reasonable projection about future performance. So stick to consistent performers with a business model you understand. In other words, avoid bank stocks like the plague.
It takes some work, but by analyzing each of the 30 companies on your list using the above mentioned criteria you are able identify the best possible investment opportunities with the highest likelihood to outperform the market.



Step 3: Estimate intrinsic values

Goal: find out if any of the opportunities you identified are currently undervalued

Step 3 - Calculate intrinsiv values - How to Find Undervalued Stocks

Now that you have a handful of wonderful companies left, it is time for the final exciting step: checking if the price is right to buy!

A right price is a price which gives you a wide margin of safety, so that you have minimal downside risk even if the future performance of the company is not entirely as expected. For example, only consider buying when the current stock price is 25% - 50% lower than the intrinsic value of the stock. This way, much of the downside risk is negated because the stock is already very cheap, while simultaneously increasing the odds of generating serious returns.  Mohnish Pabrai describes this low-risk, high reward strategy as: "heads you win, tails you only lose a little." A low purchase price is absolutely crucial if you want your dream of market beating returns to come true.

There are several ways to calculate the intrinsic value of a company, like:

Price-Earnings multiple
This method calculates a 5 year price target based on a reasonable, historical P/E valuation and then arrives at an intrinsic value estimate by taking the NPV.
Discounted Cash Flow (DCF) model
A powerful intrinsic value calculation based on the discounted value of the cash that can be taken out of a business during its remaining life.
Return on Equity valuation
The third and final method that I explain in the eBook uses one of Warren Buffett's favorite metrics of profitability: Return on Equity (ROE).
If you fill in your name and email address in the form below this post, you'll receive three spreadsheets and an ebook for free, including a DCF valuation spreadsheet

Of course I could explain all three of these models here in detail, but I have already written a free 19-page eBook called How to Value Stocks on this exact subject!

Use the above mentioned valuation models to estimate a company's intrinsic value. The very last step is then to compare this value you calculated with the price the stock is currently trading at. Is the price way below your estimate of the intrinsic value? Congratulations, you just struck gold! Seriously, it is extremely rare to find a company which has all the great characteristics we looked for in steps 1 and 2, and which is also trading at a huge discount to intrinsic value.

At this point, double check your analysis and re-run the numbers. If you are certain you have found a wonderful company which is severely undervalued, load up BIG TIME! Again, you are lucky if you find a handful of opportunities like this in a year. If you find more than that, either the stock market just crashed or your filtering criteria are not strict enough.

If the price is not right at this particular moment, add these stocks to your watch list nonetheless so you are there when the opportunity presents itself to load up at an attractive price.



Final words

Well, you just read the longest blog post I have ever written. I hope you learned a thing or two from it. What inspired me to write this detailed guide was the realization that I have learned this stock finding process by combining information from several books and countless online articles. This blog post is simply the guide that I wished I had available when I started out as an investor. If you found this guide useful, please share it freely across the interwebz and earn my eternal gratitude!

I've been studying the investment strategies of the best investors in the world for years, and have combined all this knowledge into one overcomplete training program. If you want to learn how to invest like the pros, check out my Value Investing Bootcamp video course here.

https://www.valuespreadsheet.com/value-investing-blog/how-to-find-undervalued-stocks-in-3-simple-steps

Thanks Nihal.
(Hope HUNTER would add something more soon).

Value Investing: Finding Undervalued Stocks

By Amy Fontinelle
There are two basic steps to finding undervalued stocks: developing a rough list of stocks you want to investigate further because they meet your basic screening criteria, then doing a more in-depth analysis of these stocks by examining the financial data of the selected companies.
The internet has made it easy, fast and free to find the information you need to value a company's stock. You can search for a company's financials through online databases such as Edgars and Sedar or find quarterly reports and press releases on the company's official website. Major financial website (including Investopedia.com) allow investors to get information such as stock price, shares outstanding, earnings per share and current news regarding the comapn/industry. You can also see who the stock's largest owners are, which insiders have placed trades recently and how many shares they traded. Some websites will also filter stocks according to criteria you set, such as stocks with a certain P/E ratio. These filters can help you come up with a broad list of stocks that you want to research further.

Recall Benjamin Graham's rule that an undervalued stock is priced at least a third below its intrinsic value. So how do you determine a company's intrinsic value, especially if you didn't go to business school and have no idea how to value a company? Open your spreadsheet software and we'll perform some simple calculations with stock data you can find online.
Basic Value Investing Ratios
P/E Ratio
You've probably heard financial analysts comment that a stock is selling for some number "times earnings," such as 30-times earnings or 12.5-times earnings. This means that P, the price the stock is currently trading at, is 30 times higher than E, the company's annual earnings per share, or EPS.. However, for now, all you need to know is that value investors like the P/E ratio to be as low as possible, preferably even in the single digits. The number that results from calculating P/E is called the earnings multiple. So a stock that sells for $50 (P) and generates $2 EPS (E) would have an earnings multiple of 50/2, or 25. A value investor would normally pass on this stock. (For more information, read Investors Beware: There Are 5 Types Of Earnings Per Share.)
Earnings Yield
Earnings yield is simply the inverse of the earnings multiple.. So a stock with an earnings multiple of 5 has an earnings yield of 1/5, or 0.2, more commonly stated as 20%. Since value investors like stocks with a low earnings multiple and earnings yield is the inverse of that number, we want to see a high earnings yield. Orimarily a high earnings yield tells investors that the stock is able to generate a large amount of earnings relative to the share price.
Some of the information that will help you find undervalued stocks does not require you do to any math, but it does require you to do research beyond the stock quote.
Insider Purchasing Activity
For our purposes, insiders are the company's senior managers and directors and any shareholders who own at least 10% of the company's stock. A company's managers and directors have unique knowledge about the companies they run, so if they are purchasing its stock, it's reasonable to assume that the company's prospects look favorable.

Likewise, investors who own at least 10% of a company's stock wouldn't have bought so much if they didn't see profit potential. If they're buying even more, they must be seeing greater profit potential. (To learn more, read What Investors Can Learn From Insider Trading.)
On the other hand, a sale of stock by an insider doesn't necessarily point to bad news about the company's anticipated performance - the insider might simply need cash for any number of personal reasons. Nonetheless, if mass sell-offs are occurring by insiders, such a situation may warrant further in depth analysis of the reason behind the sale.
How do you know what insiders are doing with their stock holdings? Insiders are required to report their stock purchases to the SEC within two business days. This information is freely available through the SEC website and is reported on SEC Form 4. It is also often available through various financial websites which aggregate this information.
The Art Of Value Investing
The key to buying an undervalued stock that is actually worth more than it is currently trading for is to thoroughly research the company and not just buy a stock because a few of its ratios looks good or because its price has recently dropped. It's not quite that simple to tell if a stock is a good buy. Applying your common sense and critical thinking skills to stock selection is essential.
Value investor Christopher H. Browne of the legendary value-investing firm Tweedy, Browne recommends asking a series of questions about a company in his book "The Little Book of Value Investing." Think about the company's future prospects - can the company increase its revenue by raising prices? Increasing sales? Lowering expenses? Selling or closing unprofitable divisions? Growing the company? Who are the company's competitors and how strong are they?
What you think the answers to these questions are is where value investing becomes a bit of an art form. It's also why you can't just plug some numbers into a software program to determine the best stocks to invest in.
To increase your odds of accurately answering these questions, it's wise to buy companies that you understand. Warren Buffett takes this approach. Companies that you understand will most likely be those in industries you have worked in or sell consumer goods products that you are familiar with. If you've worked for a biotech company for several years, you probably have a better-than-average understanding of the biotechnology business. And if you buy basic items like cars, clothes, appliances and food, you know a thing or two about consumer goods.
Well known investor Peter Lynch strong advocated such a strategy whereby retail investors can outperform institutions simply by investing in what they know before Wall Street catches on.
Another strategy that value investors favor is to buy companies whose products or services have been in demand for a long time and are likely to continue to be in demand. Looking at stock quotes won't tell you which companies these are - you'll have to do some critical thinking. Of course, it is not always possible to predict when innovation will make even a longstanding product or service obsolete, but we can find out how long a company has been in business and research how it has adapted to change over time. At this point it may be worthwhile to analyze management and the effectiveness of corporate governance to determine how the firm reacts to changing business environments.
Next, we'll talk about how to use the information in companies' financial statements to find undervalued stocks.
Read more: http://www.investopedia.com/…/value-i…/value-investing3.asp…

Thanks again Nihal.
(I am no expert and I use my gut feelings to place my money but knowing there are other and sure methodologies to do so is comforting to know).
Please continue with the good works.
Now we are (not)  Talking ( politics ) .

Thanks Nihal adding value to our forum.

As usual very interesting thoughts.
Thanks for sharing.

Thanks Nihal.
Valuable.

Thanks Nihal for sharing.

Timely. Thanks Nihal.