November 10, 2011 | In: General
How To Tell If a Stock Is Undervalued
Every investor wants to invest in a stock that is undervalued, because every investor knows that an undervalued stock will pop at one point. But how can we know that a stock is really undervalued, are there some signs?
Well, there are several signs that tell us if a stock is undervalued or not, some are measurable metrics, others are non-measurable signs.
Measurable Metrics That a Stock Is Undervalued
- Low P/E ratio with respect to the company’s industry: It is not wise to say that a stock with a low P/E ratio is a good stock (in fact, the stock with the lowest P/E is one of the worst performers on the stock market), and while it’s true that the P/E ratio is not that relevant anymore in evaluating a stock, it is still worth a look, here’s how: Just take a look at the P/E ratio of the stock, and compare it to the P/E ratio of similar companies in the same industry. If the P/E ratio is low, then it is possible to take this as a sign that the stock may be undervalued.
Low price per book value: The book value is the price that the company thinks its stock is worth after considering all its assets and liabilities. For example, Bank of America has a book value $20.80, while it’s current price is $6.16. This means that the price per book value is 0.29 (6.16/20.80), which is very low. A price per book value lower than 1 means that the stock is currently trading lower than what its company believes its worth. (Note: Here’s a list of high volume stocks trading below their book values).
Low price per free cash flow ratio: The free cash flow is the money that a company generates (per share) after taking into consideration the different expenses. The higher the free cash flow the better the stance of the company is (and, consequently, its stock). The stock price per free cash flow is just the division of the stock price by the free cash flow, which means that the lower it is (since we are dividing by the free cash flow which should be high for the stock to be undervalued), the more undervalued the stock is.
Now that we have examined the measurable metrics that will tell us if a stock is undervalued, let’s check non-measurable signs.
Non-Measurable Signs That a Stock Is Undervalued
- Strong fundamentals but poor stock: Imagine, for a moment, that Apple is performing badly, yet we know how good Apple is doing and how good it will do in the future (provided they keep the momentum). When you know for sure that a company is doing badly in the stock market, but performing well in the actual market (selling many products, excelling at customer satisfaction, etc…) then it’s a sure sign that its stock is undervalued (probably some investors decided to punish it). Although the saying “Buy the rumor, sell the news” is very valid in the stock market, it never lasts, and only the fundamentals of the stock and the company prevail.
Great industry: We all know that currently one of the hottest industries is the technology industry, and the hottest niche is the pads (many analysts believe that there will be more pads sold than computers within the next few years). So, if a company’s main business is in that industry, and the company is not performing well, then the stock may be undervalued.
Low evaluation when compared to peers: A great way to assess a stock is to compare it to its peers (a company of a similar size in the same industry doing the same business); if the stock is performing badly with respect to its peers, then the stock may be undervalued. I have written about this before when comparing RIG to NE.
Insiders are buying the stock: It’s a fact that insiders know more about their own company (and its stock) than the rest of the world, which means that, most of the times, they buy when they think the stock is worth buying. If you see insiders buying, then you can take this as a sign that the stock is undervalued.
Now if you want to measure how undervalued a stock is, then just add 1 for every criteria in the above list that the stock matches. The higher the total number is, the more undervalued the stock is. For example, if a stock is in a great industry (+1) and has a low P/E ratio (+1) and its company has strong fundamentals (+1), then this means that the undervaluation score is 3/6, which is not bad. A score of 7/7 means that the stock is definitely undervalued.
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