4 ways to tell if a stock is undervalued

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Everyone loves a good deal. Whether you’re buying your weekly groceries or haggling over the price of a new car, there’s nothing like getting a bargain. Though you may not think of it the same way, investing in the stock market is no different.

While people are typically excited to see their favorite items on sale at the grocery store, they can often be less enthusiastic when they see stock prices fall. But the stock market’s swings create plenty of profitable bargains for those willing to look closely.

Here are four ways to tell if a stock is undervalued.

What does it mean for a stock to be undervalued?

Before you start bargain hunting, you’ll need to understand what it means for a stock to be undervalued in the first place. Stocks represent partial ownership stakes in real businesses that (hopefully) generate earnings and cash flow for their shareholders.

A company’s intrinsic value, or what the business is worth, is based on the amount of cash flow the company will generate for shareholders over its life, discounted back to the present at an appropriate interest rate.

For a stock to be undervalued, it should be trading below a conservative calculation of its intrinsic value. Oftentimes, market commentators segment the investment universe into two categories: growth and value. But companies that are growing can still be undervalued and companies that appear to be undervalued can actually be in decline.

The following tips and clues can help determine whether a stock is undervalued.

1. Low valuation ratios

One of the quickest ways to gauge whether a stock is undervalued is to compare its valuation ratios to the rest of its industry or the overall market. If the ratios are below that of the industry average or a broad market index such as the S&P 500, you may have a bargain on your hands.

It should be noted that no financial ratio is perfect, and investors should always seek to understand the “why” behind a disconnect between the way one company is being valued compared to others.

Here are some of the most common valuation ratios to follow.

P/E ratio

The price-to-earnings (P/E/) ratio is one of the most popular ratios used in investment analysis. It compares the price of a company’s stock to its earnings per share and helps to measure how much investors are getting in earnings power relative to the price they’re paying for the stock. In general, it’s better to pay a low multiple of earnings than a high one, but there are exceptions.

The P/E ratio can be thought of as a way for the market to price a company’s future prospects. Businesses expected to grow their earnings at a high rate typically trade at higher P/E ratios than businesses with low growth prospects. The ratio also depends on the market’s confidence in that future growth, so well-positioned businesses may trade for higher multiples than businesses with a lot of variability in their future outcomes.

As with any ratio, it’s important to understand the limits of the P/E ratio. It doesn’t work well for companies that report losses or have extremely low earnings figures. In recent years, Amazon’s stock has performed extremely well despite having a very high P/E ratio. The company’s low reported earnings pushed the ratio up as management reinvested in the business to fuel future growth.

Some investors incorporate growth projections by using the price-to-earnings growth ratio, or PEG. A PEG ratio above 2 is usually considered expensive, while a ratio below 1 may indicate a good deal. Keep in mind that if your projections about future growth are off, the ratio won’t have much value to you and may signal the wrong investment decision.

EV/EBIT

The enterprise value (EV) to EBIT is very similar to the P/E ratio, but it uses more than just price and earnings-per-share in its calculation. EV accounts for debt that the company may use for financing and EBIT refers to earnings before interest and taxes.

EV can be calculated by adding a company’s interest-bearing debt, net of cash, to its market capitalization. By using EBIT for the earnings figure, you can more easily compare the actual operating earnings of a business with other companies that may have different tax rates or debt levels.

Price-to-sales

The price-to-sales (P/S) ratio is fairly simple and is calculated by dividing a company’s market capitalization by its revenue over the previous 12 months. This ratio can be useful for companies that have low or negative earnings due to one-time factors or are in their early stages and investing heavily in the business. Remember that generating sales is not the ultimate goal for an investor, but rather profits, so be careful not to rely on this ratio exclusively.

The software industry is an area where the P/S ratio may be useful in valuation analysis. Software companies can be extremely profitable, but often invest capital heavily during the early stages of their business, causing them to report negative earnings, or losses. By using the P/S ratio, you can get a sense for the valuation despite the companies’ reporting losses. Be sure you understand how they plan to make money eventually, however.

2. Company insiders are buying

Another less quantitative way of determining if a stock may be undervalued is to see if company insiders are buying the shares. Company executives typically know the business better than anyone, so it’s worth paying attention when they buy the stock. These insider transactions are reported in filings with the Securities and Exchange Commission and can be found through the agency’s website.

But be sure to read the filings carefully. Executives are often awarded shares as part of their compensation, which is very different from executives who uses their own money to purchase shares in the open market. When executives spend their own cash to buy shares, you can be fairly certain it’s because they think it’s a good investment.

Early in 2022, Netflix CEO Reed Hastings purchased about $20 million worth of stock after the company issued a disappointing outlook that caused the stock price to plummet. It proved to be a successful investment. Netflix rose from $356 per share on Jan. 26, the day Hastings bought in, to $614 at the time of this writing (May 8, 2024), an increase of 72 percent per share.

3. The stock price has meaningfully declined

If you’re not sure where to start looking for stocks that might be undervalued, stocks that have already fallen significantly from recent highs – 20 percent or more – isn’t a bad place to start. By narrowing your search to stocks that are meaningfully below their highs, you’re increasing your chances of finding a bargain. It’s like shopping in the clearance section of your favorite store – there might be some duds and items that are on sale for a reason, but you can find some real gems as well.

Several websites publish lists of stocks reaching new 52-week lows. From there, you can sift through the companies and see how they’ve been performing, what their valuation ratios look like and whether insiders have been picking up shares.

The best brokers for stock trading can help you screen for stocks that have fallen meaningfully.

4. Successful investors are buying

Another hint that a stock might be undervalued is if successful investors are gobbling up the shares. Copying off the smartest kids in class gets you in trouble in school, but it’s completely acceptable in the world of investing.

Each quarter, professional investors who manage a certain amount of money are required to disclose their holdings in a filing with the SEC. The filing shows most of the positions held by these investors as of the most recent quarter end. Filings are typically made within 45 days of the end of the quarter, so you’re not getting the data in real-time, but for long-term investors, the holdings don’t change much from quarter to quarter.

Be sure to do your own research before purchasing a stock held by well-known investors, though. If the stock price falls or climbs in between filings, you’ll need to have your own opinion on what to do with the stock.

Check out Warren Buffett and Berkshire Hathaway’s latest portfolio moves here.

Bottom line

Identifying undervalued stocks isn’t easy and ultimately involves making more accurate predictions of the future than the market. Many people have tried and failed at picking individual stocks that will outperform the market. Another approach is to buy an S&P 500 index fund that will give you access to a diversified portfolio of the top U.S. stocks at a low cost. Most professional investors fail to beat this benchmark over the long term.

But if you do decide to go bargain hunting, focus on a company’s valuation ratios, what company insiders are doing and whether smart investors are picking up the shares. It’s a good idea to check the 52-week low list if you’re looking for a place to get started. If you’re successful, you could end up picking one of the best performing stocks on the market while it’s still a diamond in the rough — and long before other investors start buying in and driving up the price.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.