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There are many competing investment theories about finding the “best” investments based on your time frame, risk tolerance and specific objectives. One approach, dating back at least to Benjamin Graham's 1949 book, The Intelligent Investor, is to identify undervalued stocks that, for one reason or another, are selling at prices far below their underlying values.
In this guide, we will look at why a stock may be undervalued and how to find an undervalued stock so you can make the best investment decisions for your goals.
5 ways to find undervalued stocks
Successfully finding undervalued stocks takes more skill than throwing a dart at the stock section of the Wall Street Journal. Investors with consistent, long-term success often use a combination of metrics and calculations to pick undervalued companies. Here are some of the ways that people determine whether a stock is undervalued.
1. Find undervalued stocks using a stock screener
2. Spot undervalued stocks with fundamental analysis
3. Identify undervalued stocks through key ratios
4. Use technical analysis to find undervalued stocks
5. Discover undervalued stocks with stock picking services
Wise takeaways
- An undervalued stock is a stock that is believed to have an intrinsic value higher than what it is currently trading for.
- Investors use different criteria and methods to decide if a stock is undervalued, such as various ratios, using fundamental analysis, looking at moving averages, patterns and more.
- Stock screeners allow investors to filter stocks by specific criteria like earnings ratios, dividend yields, and industry performance.
- Even with the right tools, investing in undervalued stocks requires patience, ongoing research, and a clear understanding of your financial goals.
1. Find undervalued stocks using a stock screener
While you can look at analyst ratings, news reports and other sources, one of the best ways to identify undervalued stocks is using a stock screener. A stock screener is a tool that helps you filter through an extensive list of stocks based on company financial data and other inputs.
There are many high-quality, easy-to-use stock screeners available. Some are free, though you’ll have to pay for the most advanced features. Depending on your investment goals, you may use a pre-defined screener or build your own to help you narrow down to a list of the best stocks for your portfolio.
Our pick for stock screeners
This large investment research organization provides information on stocks, bonds, mutual funds, ETFs and more. Morningstar offers many stock picks to its community for free.
2. Spot undervalued stocks with fundamental analysis
Fundamental analysis is the use of financial metrics and comparisons to determine the target value of a stock. Professional and advanced investors often use a combination of methodologies. Some of the most important fundamental analysis ratios and tools used in stock valuations include:
- Discounted cash flow analysis: A discounted cash flow (DCF) analysis involves projecting a firm’s future cash flows and using those projections to determine a company’s current value.
- Dividend discount model: With the dividend discount model, you use a company’s current and projected dividend payments to determine the intrinsic value of a stock.
3. Identify undervalued stocks through key ratios
One way to identify undervalued stocks is by comparing a company’s financial metrics to those of its industry peers. This method, known as ratio comparison, helps estimate a company’s value based on how it stacks up against competitors.
Some of the most commonly used valuation ratios include:
- Low price/earnings ratio: The P/E ratio compares a company’s share price to its earnings per share. A relatively low P/E ratio might suggest the stock is undervalued compared to peers — but it’s not always a sure sign of a bargain. Sometimes, low P/E ratios reflect deeper issues, such as declining performance or poor future prospects that professional investors may already be aware of. In general, though, the P/E ratio is a useful starting point when searching for undervalued stocks.
- Low price/earnings growth ratio: The price/earnings growth (PEG) ratio is considered more accurate than just a company's P/E alone. When you're looking at a stock, take the P/E ratio and divide by the earnings growth rate. If the ratio is less than 1, investors may be giving more weight to past performance than to future growth opportunities. Be aware that growth projections are just that, however: projections.
- Low market-to-book ratio: A low market-to-book ratio may indicate that a company’s stock is undervalued. This ratio compares a company’s market value (its total market capitalization) to its book value (total shareholder equity). When the market value is significantly lower, it could mean investors are overlooking the company’s true worth. For example, a toy company might own valuable real estate, making its total assets more valuable than its toy operations suggest. If those underlying assets are underestimated by the market, the stock price may not reflect the company’s actual value — potentially creating a buying opportunity.
4. Use technical analysis to find undervalued stocks
Technical analysis is a short-term valuation method where you predict future stock prices based on recent and historic patterns. Active stock traders use charts and technical analysis tools to look for stocks they believe are on the way up.
- Moving averages: Looking at a stock’s 50-day moving average compared to the 200-day moving average is a popular method of finding stocks that may be a buy or sell opportunity. This is just one of many uses of moving averages and trendlines when looking to profit in the stock market.
- Pattern analysis: Traders use additional overlays to find specific patterns and potential buy or sell points. For example, Bollinger Bands are used to find buy and sell levels using standard deviations and moving averages together.
- Lagging relative price performance: If a company's share price is lower than those of its industry peers, this may reveal an underperformance situation. This could happen for several reasons. In the screener you use, there will be an option to compare individual stock price histories over various periods against other individual stocks and against stock indexes.
Our top pic for stock market research
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5. Discover undervalued stocks with stock picking services
In addition to building your own screeners, you can choose to invest in stocks found through a stock picking service. These services rely on teams of professional investment analysts who help you find high-quality investment opportunities.
Stock picking services may be a good fit for your goals, but keep in mind that any other subscriber has access to the exact same list. That can quickly increase the price of a stock recently recommended by a large newsletter or website.
Our pick for a stock picking service
If you invest in single stocks, it's not always easy to pick the next winner in the stock market. The Motley Fool is a well-respected stock picking service with a nearly 30-year track record.
Be cautious when picking undervalued stocks
If it were easy to pick undervalued stocks, everyone would be doing it. But investors with patience and the right strategy may find success beating the market by investing in undervalued stocks.
When investing in any asset, including the stock market, it’s essential to weigh out risk and potential returns so you make investment decisions appropriate for your unique investment goals and experience. When you pay close attention to intrinsic value, you may be on track to find the ideal mix of undervalued stocks to set yourself up for financial success.
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Fred Whittlesey
Freelance Contributor
Fred Whittlesey is a freelance contributor for Moneywise.
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