What Does Overvalued Mean?
An overvalued asset is an investment that trades for more than its intrinsic value. For example, if a company with an intrinsic value of $7 per share trades at a market value $13 per share, it is considered overvalued.
An investment is other undervalued or overvalued compared to its intrinsic value. Because an investment’s intrinsic value is subjective, so is its “over/under” valued label.
As a refresher, the intrinsic value of an investment is the price a rational investor would pay for the investment. The concept is most commonly represented by the Net Present Value (NPV) Net Present Value (NPV) Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present. NPV analysis is a form of intrinsic valuation and is used extensively across finance and accounting for determining the value of a business, investment security, of all future cash flows the investment will produce. For a recap on the subject, please see CFI’s valuation methods guide Valuation Methods When valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent , as well as the financial modeling guide Free Financial Modeling Guide This financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more , and types of financial models Types of Financial Models The most common types of financial models include: 3 statement model, DCF model, M&A model, LBO model, budget model. Discover the top 10 types .
Undervalued vs. Overvalued
If the value of an investment (i.e., a stock) trades exactly at its intrinsic value, then it’s considered fairly valued (within a reasonable margin). However, when an asset trades away from that value, it is then considered undervalued or overvalued.
Value vs. Growth Investing
Investors who subscribe to the concept of value investing will not purchase stocks that are above their intrinsic value. Instead, they only look for opportunities to find “cheap” stocks. The opposite of a value investor is a growth investor, which is someone who believes that the stock is, in fact, not too expensive and will deliver more growth then the market (i.e., other investors) expect.
Short vs. Long Strategies
When a stock is overvalued, it presents an opportunity to go “short” by selling its shares. When a stock is undervalued, it presents an opportunity to go “long” by buying its shares. Hedge funds and accredited investors sometimes use a combination of short and long positions to play under/overvalued stocks. To learn more about trading, check out CFI’s technical analysis guide Technical Analysis – A Beginner’s Guide Technical analysis is a form of investment valuation that analyses past prices to predict future price action. Technical analysts believe that the collective actions of all the participants in the market accurately reflect all relevant information, and therefore, continually assign a fair market value to securities. .
Ratios for Overvalued Investments
There are many tools investors can use to discover assets (usually stocks) that are worth less than the price they have to pay for them. Here are some examples of commonly used ratios for assessing whether a stock is undervalued or not:
Price vs. Net Present Value (P/NPV)
Price-to-NPV is the most complete method for valuing an investment. To perform P/NPV analysis, a financial analyst will create a financial model in Excel to forecast the business’ revenues, expenses, capital investments, and resulting cash flow into the future to determine the Net Present Value (NPV) Net Present Value (NPV) Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present. NPV analysis is a form of intrinsic valuation and is used extensively across finance and accounting for determining the value of a business, investment security, .
Next, the financial analyst will compare the resulting value from the Discounted Cash Flow (DCF) analysis to the market value of the asset. Check out CFI’s free financial modeling guide Free Financial Modeling Guide This financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more to learn more.
More Valuation Ratios
If a financial analyst doesn’t have enough time or information to create a financial model from scratch, they may use other ratios to value the company, such as:
- Enterprise Value to Revenue
- Enterprise Value to EBITDA
- Price to Earnings
- Price to Book Value
- Price to Cash Flow
- Dividend Yield and/or Dividend Payout Ratio
When using the financial ratios above, it’s important to avoid falling into the “overvalued trap.” Since companies can regularly have fluctuations in their financial statements, the ratios may appear more unfavorable then they should be over the long term.
A company can often incur one-off expenses on their Profit and Loss (P&L) Statement Profit and Loss Statement (P&L) A profit and loss statement (P&L), or income statement or statement of operations, is a financial report that provides a summary of a or include an asset write-down on their Balance Sheet when such accounting practices don’t automatically represent the long-term expected performance of the company.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
- DCF Model Guide DCF Model Training Free Guide A DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow
- Long and Short Positions Long and Short Positions In investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short).
- Stock Investing: A Guide to Growth Investing Stock Investing: A Guide to Growth Investing Investors can take advantage of new growth investing strategies in order to more precisely hone in on stocks or other investments offering above-average growth potential.
- Stock Investing: A Guide to Value Investing Stock Investing: A Guide to Value Investing Since the publication of “The Intelligent Investor” by Ben Graham, what is commonly known as “value investing” has become one of the most widely respected and widely followed methods of stock picking.
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For investors in the equity markets, determining a stock’s intrinsic value is important in trying to determine whether it is overvalued or undervalued. Intrinsic value is the calculated value of a company using fundamental analysis, which takes into account a variety of quantitative factors. The intrinsic value is usually different than the current market value.
While intrinsic value is often relied on as a base case, many investors and analysts often use a variety of ratios for providing a quicker and easier estimation for a stock’s price. Ratio analysis is also often viewed in conjunction with intrinsic value calculations.
- Ratios can be used for an estimation of a stock’s value.
- Stock ratio values can be faster and easier options than fundamental intrinsic value models.
- Alternative ratio methods can help in estimating the value of a non-public company or a company in distress.
Ratios and Sectors
In general, the use of ratios is often studied within a particular sector. Stock ratio analysis can provide a quick look at the reasonability of a stock’s price, as well as its likelihood of being overvalued or undervalued.
Analysts can also use ratios in fundamental intrinsic value models. Particularly, ratio multiples are used for identifying terminal value calculations as well as creating valuations when free cash flow, operating income, and net income are unreliable or nonexistent.
Comprehensively, there are 100s of ratios that investors can study or use in different types of analysis. Investopedia discusses stock ratio analysis from a multitude of different angles across its website platform.
Below are a few popular ratios that can provide some quick insight into a stock’s price.
P/E and PEG
The price-to-earnings ratio (P/E) can have multiple uses. By definition, it is the price a company’s shares trade at divided by its earnings per share for the past twelve months. The trailing P/E is based on historical results, while forward P/E is based on forecasted estimates. In general, P/E is often classified as a type of profitability ratio.
Given a company’s historical earnings per share results, it could be easy for an investor to find an estimated price per share of a stock using the average of P/Es from some comparable companies. Moreover, viewing an actual P/E of a company can also provide insight on the reasonability of the stock when compared to its peers.
The higher the P/E the more speculation is priced into the value, usually from bullish expectations of future potential. This means investors in the public market are willing to pay more per dollar for every $1 of earnings the company produces. Lower P/E’s are usually more reasonable but can also indicate potential undervaluation if considerably lower than peers.
The price-to-earnings growth ratio (PEG) is an extended analysis of P/E. A stock’s PEG ratio is the stock’s P/E ratio divided by the growth rate of its earnings. It is an important piece of data to many in the financial industry as it takes a company’s earnings growth into account, and tends to provide investors with a big picture view of profitability growth compared to the P/E ratio.
While a low P/E ratio may make a stock look like it’s worth buying, factoring in the growth rate may tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance. The degree to which a PEG ratio value indicates an over or underpriced stock varies by industry and by company type. Also, a PEG ratio below one is typically thought to indicate that a stock may be underpriced, but this can vary by industry.
The accuracy of the PEG ratio depends on the accuracy and reliability of the inputs. Moreover, the PEG can be calculated with both trailing and forward growth rates. Depending on the analysis, trailing and forward may differ substantially, which will influence the PEG.
The price to book (P/B) is another ratio that incorporates a company’s share price into the equation. The price to book is calculated by share price divided by book value per share. In this ratio, book value per share is equal to a company’s shareholder’s equity per share, with shareholders’ equity serving as a quick report of book value.
Similar to P/E, the higher the P/B, the more inflated a stock’s price is. Vice versa, the lower the P/B the greater the potential for upside. Both P/E and P/B are often best viewed in comparison to the ratios of their peers. P/B is often considered a type of solvency ratio.
The price-to-dividend ratio (P/D) is primarily used for analyzing dividend stocks. This ratio indicates how much investors are willing to pay for every $1 in dividend payments the company pays out over twelve months. This ratio is most useful in comparing a stock’s value against itself over time or against other dividend-paying stocks.
Alternative Methods Using Ratios
Some companies don’t have operating income, net income, or free cash flow. They also may not have these reports far into the future. This can be likely for private companies, companies recently listing initial public offerings, and companies that may be in distress. As such, certain ratios are considered to be more comprehensive than others and therefore better for use in alternative valuation methods.
The price-to-sales (P/S) ratio is often popular because most companies do have sales. These sales will also show some type of growth rate.
The P/S ratio is figured by dividing the current stock price by the 12-month sales per share. The current stock price can be found by plugging the stock symbol into any major finance website. The sales per share metric is calculated by dividing a company’s 12-month sales by the number of outstanding shares. A low P/S ratio in comparison to peers could suggest some undervaluation. A high P/S ratio would suggest overvaluation.
Some companies may not be publicly traded. In this case, there is no public share price or public shares outstanding. Thus, using enterprise value can be helpful.
Enterprise value is an alternative to market capitalization. The main difference is that it factors debt into the equation. For a non-public company, calculate enterprise value-to-sales (EV/S) by adding the shareholders’ equity and total debt then subtracting cash. For a public company, enterprise value can be calculated by simply using the market cap plus the total debt and subtracting cash. Comprehensively, enterprise value is a view of the company’s capitalization.
EV-to-EBITDA is similar to EV/S. However, EV/EBITDA requires a company to have a reasonable level of operating income combined with depreciation and amortization. Enterprise value is calculated in the same way as above. EBITDA is calculated by adding depreciation and amortization to operating income (also known as EBIT). EV/EBITDA and other EBITDA multiples are commonly used in merger and acquisition analysis.
We can determine the intrinsic value of a stock based on its dividend growth.
There are many different ways to determine the intrinsic value of a stock. One popular method is the dividend discount model, which uses the stock’s current dividend and its expected dividend growth rate to determine its theoretical current stock price. Here’s how to apply this model to your own stocks, and how to use the results in your investment research.
The dividend discount model
This valuation method is passed on the theory that a company’s stock price should be derived from the present value of all of its future dividends. To calculate the valuation of a stock based off its dividends, the most commonly used equation is the Gordon growth model, which looks like this:
In the equation, here’s what the variables mean:
- “P” stands for the stock’s price based off its dividends. In other words, this is the theoretical valuation you’re calculating.
- “D1” stands for the stock’s expected dividend over the next year. For the purposes of this calculation, you can assume that next year’s dividend will grow at the company’s historical rate of dividend increases.
- “r” stands for the required rate of return. In other words, if your goal is to produce annual returns of 10% from your investments, you should use 0.10 here (10% written as a decimal).
- “g” stands for the expected dividend growth rate. For stocks with a long history of dividend growth, you can simply use the historical average dividend growth rate. You may be able to find this on certain websites, or you can calculate it as:
For example, if a company paid a $0.10 dividend 20 years ago, and pays a $0.80 dividend now, its dividend growth rate would be $0.80/$0.10, or 8, raised to the power of 0.05. Using a calculator, you can find that this company’s average historical dividend growth rate is 11%.
Re-writing the Gordon growth model formula in plain English, we have:
Keep in mind that this model is only effective when applied to stocks with a long and steady history of dividend increases — it won’t provide an effective valuation for stocks that recently started paying dividends, or stocks with erratic dividend histories.
To illustrate this point, let’s say I want to determine whether or not Coca-Cola is a good buy right now. The company currently pays an annual dividend of $1.32, and based on the dividend growth formula I mentioned earlier, I calculate that the company has historically increased its dividend at an average rate of 8.6% per year over the past two decades. So I can assume that next year’s dividend should be in the ballpark of $1.43.
I typically shoot for annual returns in the 10-12% range on my investments, so I’ll use the midpoint, or 11% for my required rate of return. Putting this all together in the Gordon growth model, I can calculate Coca-Cola’s value (to me) as:
Since Coca-Cola is trading for just $42.55 as of this writing, this model tells me that it could be a good value investment at the current share price.
There are a few things to remember about this formula. For one thing, an investment’s past performance doesn’t guarantee its future, and that’s definitely true when it comes to dividends. Just because Coca-Cola historically increased its dividend by 8.6% per year doesn’t mean it will keep doing so — especially if the current low-interest environment persists or in another recession hits.
The bottom line is that as long as you realize that this is a theoretical valuation that’s based on several assumptions, it can be a useful tool for finding attractively priced stocks for your portfolio.
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The present value, or PV, of an expected stock price is the amount you would realistically pay today if you expect the stock price to reach a certain level tomorrow. These calculations are used often by businesses and economists to compare cash flow at different times. You can calculate this amount using a basic financial formula for present value of a future amount.
In order to calculate the PV of an expected stock price, you can use a simple mathematical formula which incorporates any expected dividends, the expected stock price, the number of years in the future you are representing and the estimated real rate of return.
Understanding Present Value
Present value, also known as the “discounted value,” tells you what a stock is worth on the day you bought it. If you purchased shares in a company for $20 a share today, the present value is $20 a share. If you planned to put $20 a share into that same stock in a year, you can’t call that the present value, since you can’t know for sure that the stock will be worth $20 a share. But if you want to buy that stock a year from now and determine what its value will be at that time, also known as its “future value,” you would first need to understand what it is worth today, then use a calculation to determine what it will be worth in a year.
Finding the Rate of Return
Determine the expected annual rate of return for the type of stock you’re investing in. To do so, research historical rate of return data for similar stocks, or a major stock market indicator like the average historical rate of return for the S&P 500. You can sometimes find this information listed in the annual reports of public companies and respected financial publications. Assume for the purpose of an example that the expected rate of return is 7.5 percent.
Subtract the estimated inflation rate for the period, which is also available by reviewing financial publications, to determine the real rate of return. For instance, if inflation is 2.5 percent, the real rate of return is 5 percent.
Determining the Future Value
Use a simple formula to determine the present value of the stock price. The formula is D+E/(1+R)^Y where D is any dividends expected to be paid during the period, E is the expected stock price, Y is the number of years down the line, and R is the real rate of return you estimated.
Plug the numbers into the formula to complete your calculation. For example, if your expected stock price is $58 per share one year in the future, total dividends paid during the period equal $2 per share with a real rate of return of 5 percent. The present value is $2 + $58/(1+.05)^1 or $57.14.
- Money-Zine: Calculating Stock Prices
- PRESENT | definition in the Cambridge English Dictionary
Louise Balle has been writing Web articles since 2004, covering everything from business promotion to topics on beauty. Her work can be found on various websites. She has a small-business background and experience as a layout and graphics designer for Web and book projects.
Table of Contents
Determining the Value of a Stock in the Market
If someone asked five seasoned investors how to determine a stock’s value, they would likely get five different answers. Finding undervalued stocks are often difficult since the trading price is fair market value in the mind of the investor. But there are some ways to guess which stocks might be unfairly penalized and could rebound in the future.
Undervalued Stocks Based on Price to Earnings Ratio
Perhaps this is the most common available tool to determine a company’s relative worth. Also referred to as a P/E ratio, this number is the current price of the stock divided by the annual net income. If the company shares are trading at 20 dollars and the earnings for the year are two dollars, the P/E ratio is 10. If the earnings for the year were four dollars, the P/E ratio would be five.
A trader using the Internet can quickly determine a company’s P/E versus a competitor or the industry to see its relative value. A company with a P/E ratio significantly lower than its competitors or the industry average might be worth a second look as a value pick.
Valuating Based on Price to Book Ratio
Another common tool to determine a stocks relative worth is the Price to Book ratio. The book ratio is the company assets minus any intangible assets and liabilities. Another way to describe this is if the company went bankrupt and all assets were sold at fair market value, how much per share would the company have in cash?
The current trading share price is divided by this book value to come up with the Price to Book ratio. A price to book ratio under the value of one could be considered a value pick since the current net asset value is worth more than current share price.
Value Pick Based on PEG
A P/E or price to earnings ratio only tells one about the current valuation of a stock. But what role does future growth play in determining a stocks value? The PEG ratio or price to earnings plus growth solves this problem.
Having the P/E ratio, merely divide it by the annual earnings per share growth. Some will list this per annum or for five years expected. Many investment sources will automatically calculate this number.
- A PEG ratio over 1 is often considered overvalued
- A PEG ratio of under 1 is considered to be undervalued
If the P/E is 20 and the expected growth per year is 20 percent, then the PEG is 1. This is neutral. If that same stock has an expected growth of 40 percent, the PEG is 0.5 which is a value pick.
Picking Undervalued Stocks Wisely
Of course, much caution is necessary when picking stocks that may be undervalued. More often than not, there is a good reason that these companies are trading less than their counterparts. Once an investor determines that the stock might be undervalued, further investigation is necessary to see if he feels the reasons are valid or not.
There are many competing investment theories about how to find 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
Tools for Finding Undervalued Stocks
These days, there are free online tools that provide investors with the ability to search and screen investment ideas within seconds. You can start with a stock screener, such as our personal favorite Ally Invest . It offers two types of stock screeners:
1. A screener with about 80 criteria to choose from, along with six predefined screens.
2. A technical screener powered by Recognia.
Other optional stock screeners are Google Stock Screener or Yahoo Stock Screener, and if you want more in-depth search capabilities and donвЂ™t mind paying a few bucks, you can use YChartsвЂ™ Stock Screener. With a subscription to YCharts, youвЂ™ll also get access to many other investing tools.
If you already have a brokerage account, I’d recommend using its screeners. What these tools do is analyze the financial metrics of thousands of companies and deliver to you the ones that meet your input. For example, if you input “P/E must be lower than 15,” the screeners will not show you any companies with P/E ratios higher than 15.
Undervalued Stock Indicators
But how can you identify undervalued stocks? There are six criteria investors look for:
1. Low price/earnings ratio
No discussion of stock prices would be complete without referencing one of the most common, but not always the best, measures of a stock’s relative value: the price/earnings (P/E) ratio. Every company has a P/E. The higher the P/E, the higher the price of the stock relative to the earnings (profit). While a relatively low P/E ratio may indicate a buying opportunity, it’s important to remember there is likely a reason for the low P/E. For example, a company might report high earnings, but professional investors, who follow the business closely, know the company isn’t telling the whole truth. As a result, the stock price will remain low, and the P/E ratio will look appealing. These scenarios are rare, however, so you should be OK to rely on the P/E ratio to find deals.
2. 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. One example is if stock analysts show concern over certain financial metrics (like the ones listed below). It’s not unusual for a single voice on CNBC or in The Wall Street JournalВ to cause a whiplash effect as investors sell-off and drive the price down. What happens is investors drive the price too far down, to the point of making the stock price undervalued. 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.
3. 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 (e.g., a P/E of 10 and projected growth of 15%, giving us a PEG ratio of 0.66), investors may be giving more weight to past performance than to future growth opportunities. Be aware that growth projections are just that, however: projections. Read more about Growth Stock Investing
4. High-Dividend yield
Bet you didn’t think to look at the dividend yield, did you? But actually, if a company’s dividend payment rate exceeds that of its competitors, this may indicate that the share price has dipped to “undervalued” status (in relation to its dividend payment). If the company is not financially troubled and future dividend payments appear secure, the dividend opportunity can provide returns in the short term, as well as the potential for the stock price to move higher in the future. If you’re using a stock screener, use the “dividend yield %” to find undervalued stocks in a given industry.
5. Low market-to-book ratio
A company that has a low market value (total market capitalization) as a ratio to book value (total shareholder equity) may present an undervaluation situation. The key is understanding the real value of both tangible assets (land, buildings, cash) and intangible assets (goodwill, intellectual property). For example, a company that produces and sells toys might also own property. The value of the property the company owns could potentially be worth more than the toy business it operates. Investors might overlook this and the price of a stock will not reflect the underlying value of assets the toy company has on the books.
6. Free cash flow
Many investors put less emphasis on reported profit and more on free cash flow — the amount of cash generated by the business after all expenses are accounted for. A stock that appears low-priced because of lower reported earnings may be a great deal in terms of cash flow. You can find this from inside a screener or through your brokerage firm by looking for the cash/share ratio. It can be fascinating to see how two apple-to-apple companies differ in terms of cash on the books.
These metrics arenвЂ™t the be-all-end-all to determine if a stock is a good value. No single metric or measure can ensure an investor that a potential investment is undervalued. If several of these seem to be confirming an undervaluation situation, however, you may have identified a market inefficiency that is a good investment opportunity.
Investing in undervalued shares could give your portfolio a boost if they eventually see significant price appreciation. The concept of value investing, developed by Benjamin Graham and popularized by Warren Buffett, essentially means investing in shares that are undervalued by the market. When a stock’s share price is well below its intrinsic value, that can be a bargain buy for investors. The payoff comes when that stock’s price begins to rise as the market catches on to its true worth. Investors then have an opportunity to sell, ideally for a sizable profit. This is the essential goal of investing: Buy low, sell high. The question is, how do you find undervalued shares to invest in?
How to Identify an Undervalued Stock
Finding undervalued shares to invest in requires some skill and know-how when it comes to how the market works. It also requires a discerning eye, since sometimes shares can appear to be undervalued when they actually aren’t. In that scenario, you might purchase a stock on the assumption that its price will increase over time, but it doesn’t. Instead, the price flatlines or worse, decreases, meaning you realize a loss rather than a gain on your investment. This is known as the value trap.
That’s what you want to avoid with a value investing approach. With that in mind, here are four ways to accurately spot undervalued shares.
1. Check the Ratios
Several ratios can be useful in assessing a stock’s value. Here are some of the most important:
- Price-to-earnings ratio (P/E). The price-to-earnings ratio is a way to measure a stock’s relative value. It’s the ratio between a company’s share price and its earnings per share. Earnings per share is calculated by dividing a company’s profit by the total number of outstanding shares issued. A higher P/E ratio generally means a higher stock price, relative to the company’s earnings. If a company has a lower P/E ratio, on the other hand, means a stock is less expensive and could be a discounted buy.
- Price-to-earnings growth ratio (PEG). The PEG ratio is a company’s P/E ratio divided by its earnings growth rate over a set period of time. A low PEG may suggest that the market is discounting a company’s potential to grow over the long-term, resulting in an undervaluation.
- Price-to-book ratio (P/B). The price-to-book ratio is a stock’s price divided by its equity per share. When this calculation results in a number that’s less than one, it suggests that the share is trading for less than what the company’s total assets are worth.
- Current ratio. The current ratio is commonly used to assess a company’s financial health. It’s simply a company’s assets divided by its liabilities, and it’s a way to measure how easily a company can keep up with its debt obligations.
- Debt-to-equity ratio (D/E). The debt-to-equity ratio means the amount of debt a company has divided by its shareholders’ equity. A higher D/E ratio means a company relies more heavily on debt than equity to finance operations, but that should be balanced against assets, cash flow and earnings when determining value.
2. Consider Cash Flow and Dividend Yield
Some companies pay investors a dividend, which represents a share of profits. The dividend yield and current cash flow can also be significant when trying to find undervalued shares to invest in.
In terms of dividend yield, it’s important not to be distracted by the number alone. A strong dividend yield suggests that a company is paying out a decent amount of profits right now, but you have to dig deeper. Specifically, you should be looking at a company’s cash flow, debts and dividend payout history to determine if the current dividend yield is sustainable.
If a company is paying the bulk of its profits out in dividends, for example, that may leave it with less cash flow to pay off debts or invest in growth for the long-term. When it comes to finding stocks that are undervalued, the key thing to look for with dividend yield and cash flow is consistency. If a company is continually paying out a steady dividend, despite a lower share price, that’s a sign that its underlying financials are strong.
3. Compare Competitor Pricing
Another way to evaluate whether a share is undervalued is to look at similar companies in the same industry. Here, you want to make apples-to-apples comparisons between the company you think is undervalued and other companies that sell at a higher price point.
Specifically, consider what’s driving the company’s share price to be lower than the competition and how the price is trending. This is where looking at things like the moving average can be helpful. The moving average is a way to track price movements over time, accounting for both short-term and long-term pricing changes.
When looking at pricing trends, keep the drops in perspective and look at how the stock is trading relative to competitors. Also, it’s worth considering whether a competitor company is accurately valued. It could be that a competitor is overvalued, making the company you’re interested in appear to be worth less than it actually is.
4. Look at the Financials
When trying to find undervalued shares, it helps to have as complete a picture of the company’s financials as possible, not just a picture of metrics like the price-to-earnings ratio. That means reviewing the fundamentals concerning things like the income sheet, balance statement and quarterly earnings reports.
Looking at these things can help you get a better sense of how strong the company’s financial position is and how sustainable the business model is. A company that’s seeing steady positive earnings over a multi-year period with minimal debt, for example, could be a good candidate as an undervalued stock if those indicators aren’t reflected by an increasing share price. In other words, the shares could prove to be a dark horse whose potential isn’t being realized by investors.
Something else to consider is how strong a company’s financial position is, relative to its competitors. Specifically, you’d want to look for companies that may be undervalued but have opportunities to grow if a market downturn happens. These are the companies that have strong cash flow, minimal debt and are positioned to see steady or increased demand for their services or products in changing market environments.
The Bottom Line
Picking undervalued shares takes some effort. The better you understand the basics of how to identify stocks that may be undervalued, the easier it may be to use a value investing strategy to boost your portfolio’s return profile. The key is remembering that there’s no definitive set of rules for identifying the right shares to invest in and that like anything else, there’s still a certain amount of risk involved.
Discover a simple technique to calculate if a stock is a good buy, based on easily-found financial data.
This approach is similar to the techniques pioneered by Warren Buffet and Benjamin Graham.
This guide teaches you how to calculate if a stock is undervalued or overvalued, given a set of conservative assumptions about its future growth prospects, and your desired return. If the current share price is lower than a calculated fair value, then the stock is a good buy.
This indicator is, however, a rough guide, and should only be used in the context of a wider analysis and your financial goals.
All the calculations are illustrated in Excel. Here’s the complete spreadsheet, but you’ll need to read the entire article to understand the method.
We’ll assume that we’re trying to value Exxon Mobile (ticker: XOM) and we plan to hold the shares for 3 years. (You can easily extend the approach below to any other stock and holding period).
Step 1 – Collect Your Data
We’ll need the following data (all the data were correct at the time of writing – March 17th 2013)
- Current share price. XOM’s current share price is 89.37
- Current dividend per share. XOM have paid a quarterly dividend of 57 cents per share for the last 4 quarters. Hence their yearly dividend per share is 2.28.
- Current EPS. XOM have a trailing twelve month (ttm) EPS of 9.69. This is their diluted value, which accounts for outstanding options that would reduce the price.
We also need to make several assumptions
- Forward PE. Exxon’s current PE is 9.22 and forward PE is 10.93. So to be conservative, we’ll assume that the PE for the next three years will be 10.
- EPS Growth. According to the FT, XOM’s 5-year EPS growth is 5.96% (so let’s call it an even 6%).
Enter all the data into a spreadsheet like so.
Step 2 – Calculate EPS Over the Holding Period
Now we’ll need to calculate the EPS for every year that we hold XOM, given our growth rate. So we simply take our current EPS of 9.69, and consecutively multiply it by 6% for each year.
The total EPS over the holding period of 3 years is simply the EPS in Year 1, 2 and 3 added together.
These calculations are entered into Excel as follows.
So at the end of Year 3, we have a total EPS of 32.70.
Step 3 – Calculate Present Fair Value
So now comes the tricky part – calculating the present fair value of XOM’s shares, given our assumptions and parameters.
First, let’s look at the calculations in Excel, and then we’ll discuss them one by one.
The expected share price at the end of our holding period of 3 years is the EPS in Year 3 times the forward PE assumption of 11. That’s 11.54 x 10 = 115.41.
The dividend payout ratio is the current dividend per share divided by the EPS in year 3. That’s 2.28/11.54 =0.2. We’re using the EPS in Year 3 in order to be conservative and calculate a lower dividend payout ratio. (Using the current EPS would give a higher dividend payout ratio, but let’s err on the side of safety.)
The total dividends per share over the entire 3 years is the dividend payout ratio times the total EPS over the 3 years. That’s 0.2 x 32.70 = 6.46.
Hence the expected share value at the end of the 3 year holding period is the total dividends received over the 3 years plus the expected share price at the end of the 3 years. That’s 6.46 + 115.41 = 121.87.
Now, we need to discount the share value to the present day. If we expect to received a 10% yearly return for holding XOM shares for 3 years, then the present share value is 121.87/(1+0.10)^3 = 91.56
Since the current share price of 89.37 is lower than our fair value of 91.56, then XOM is undervalued. That’s a buy signal!
However, it goes without saying that this is simply an indicator. Don’t buy or sell simply based on this rather simple analysis. You may also want to contrast this approach with Graham’s Formula for valuing shares.
You can download the complete spreadsheet at the link below.
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Benjamin Graham’s seven time-tested criteria to identify strong value stocks
Value investing, perhaps more than any other type of investing, is more concerned with the fundamentals of a company’s business than its stock price or market factors affecting its price. One of the earliest proponents of this fundamentals-based value investing strategy was Benjamin Graham in the 1920s.
The details of this value strategy are spelled out clearly in his book, “The Intelligent Investor,” published 71 years ago. The objective of Graham’s strategy is to identify unappreciated stocks and show you how to find undervalued stocks that meet certain criteria for quality and quantity … stocks that are poised for stellar price appreciation.
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Benjamin Graham Value Stock Criteria List:
Value Criteria #1: Quality Rating
Look for a quality rating that is average or better. You don’t need to find the best quality companies–average or better is fine. Benjamin Graham recommended using Standard & Poor’s rating system and required companies to have an S&P Earnings and Dividend Rating of B or better. The S&P rating system ranges from D to A+. Stick to stocks with ratings of B+ or better, just to be on the safe side.
Value Criteria #2: Debt to Current Asset Ratio
Benjamin Graham advised buying companies with Total Debt to Current Asset ratios of less than 1.10. In value investing it is important at all times to invest in companies with a low debt load. Total Debt to Current Asset ratios can be found in data supplied by Standard & Poor’s, Value Line, and many other services.
Value Criteria #3: Current Ratio
Check the Current Ratio (current assets divided by current liabilities) to find companies with ratios over 1.50. This is a common ratio provided by many investment services.
Value Criteria #4: Positive earnings per share growth
Criteria four is simple: Find companies with positive earnings per share growth during the past five years with no earnings deficits. Earnings need to be higher in the most recent year than five years ago. Avoiding companies with earnings deficits during the past five years will help you stay clear of high-risk companies.
Value Criteria #5: Price to earnings per share (P/E) ratio
Invest in companies with price to earnings per share (P/E) ratios of 9.0 or less. Look for companies that are selling at bargain prices. Finding companies with low P/Es usually eliminates high growth companies, which should be evaluated using growth investing techniques.
Value Criteria #6: Price to book value (P/BV)
Find companies with price to book value (P/BV) ratios less than 1.20. P/E ratios, mentioned in rule 5, can sometimes be misleading. P/BV ratios are calculated by dividing the current price by the most recent book value per share for a company. Book value provides a good indication of the underlying value of a company. Investing in stocks selling near or below their book value makes sense.
Value Criteria #7: Dividends
Invest in companies that are currently paying dividends. Investing in undervalued companies requires waiting for other investors to discover the bargains you have already found. Sometimes your wait period will be long and tedious, but if the company pays a decent dividend, you can sit back and collect dividends while you wait patiently for your stock to go from undervalued to overvalued.
One last thought. We like to find out why a stock is selling at a bargain price. Is the company competing in an industry that is dying? Is the company suffering from a setback caused by an unforeseen problem? The most important question, though, is whether the company’s problem is short-term or long-term and whether management is aware of the problem and taking action to correct it. You can put your business acumen to work to determine if management has an adequate plan to solve the company’s current problems.
Follow these seven value investing principles, and you’ll invest like Benjamin Graham. With luck, perhaps you’ll have the same kind of success he enjoyed!
How have you used Benjamin Graham’s criteria to pick stocks and succeed? We’d love to hear your stories in the comments below.
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What Is Undervalued?
Undervalued is a financial term referring to a security or other type of investment that is selling in the market for a price presumed to be below the investment’s true intrinsic value. An undervalued stock can be evaluated by looking at the underlying company’s financial statements and analyzing its fundamentals, such as cash flow, return on assets, profit generation, and capital management to estimate the stock’s intrinsic value. In contrast, a stock deemed overvalued is said to be priced in the market higher than its perceived value.
Buying stocks when they are undervalued is a key component of famed investor Warren Buffett’s value investing strategy.
- An asset that is undervalued is one that has a market price less than its perceived intrinsic value.
- Buying undervalued stock in order to take advantage of the gap between intrinsic and market value is known as value investing.
- For a stock to be undervalued means that the market price is somehow “wrong” and that the investor either has information not available to the rest of the market or is making a purely subjective, contrarian evaluation.
Value investing is not foolproof, however. There is no guarantee as to when or whether a stock that appears undervalued will appreciate. There is also no exact way to determine a stock’s intrinsic value — which is essentially an educated guessing game. When someone says that a stock is undervalued, all they are essentially saying is that they believe the stock is worth more than the current market price, but this is inherently subjective and may or may not be based on a rational argument from business fundamentals.
An undervalued stock is believed to be priced too low based on current indicators, such as those used in a valuation model. Should a particular company’s stock be valued well below the industry average, it may be considered undervalued. In these circumstances, value investors may focus on acquiring these investments as a method of pulling in reasonable returns for a lower initial cost.
Whether a stock is actually undervalued or not is open to interpretation. If a valuation model is inaccurate or applied in the wrong way, it could mean the stock is already properly valued.
Value Investing and Undervalued Assets
Value investing is an investment strategy that looks for undervalued stocks or securities within the marketplace with the goal of purchasing or investing them. Since the assets can be acquired at a relatively low cost, the investor hopes to improve the likelihood of a return. Additionally, the value investing methodology avoids purchasing any items that may be considered overvalued in the marketplace for fear of an unfavorable return.
Undervaluation, Subjectivity, and Efficient Markets
The idea that a stock can be persistently undervalued (or overvalued) in such a way that an investor can consistently achieve above market returns by trading on these mis-priced stocks, conflicts with the idea that the stock market makes fully efficient use of all available information. If a stock were truly of greater intrinsic value than its market price, and this was readily ascertainable from its financial statements, then all market traders would have an immediate incentive to buy the stock, and in doing so bid up the price to its intrinsic value.
In other words, if markets are efficient then finding a truly undervalue stock should be near impossible (unless one has inside information not available to other market participants). This means that an investor who thinks a given stock is undervalued is inherently making a subjective judgment contrary to the rest of the market (barring insider information). It also means that the existence of successful value traders who can consistently outguess the market would be a challenge to the idea that markets are efficient.
Value Investing vs. Values-Based Investing
Value investing is the concept of buying shares in companies based on an investor’s personal values, also known as value-based investing. In this investment strategy, the investor chooses to invest based on what he or she personally believes in, even if market indicators do not support the position as profitable. This can include avoiding investments in companies with products that he or she do not support and directing funds to those they do.
For example, should an investor be against cigarette smoking, but support alternative fuel sources, they would invest their money accordingly. This type of investing implies that the investor does not believe that the market price reflects the intrinsic value of the stock due to some kind of market failure, such as an unaccounted for externality.
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Investors usually make buy and sell decisions based on stock prices — ideally, buying undervalued stocks and selling overvalued stocks. However, figuring out the true value for a stock is difficult. Stock prices usually depend on profits. Strong and rising profits usually mean rising stock prices, while weak and falling profits mean declining stock prices. Use technical charts, market sentiment and historical profits to determine if a stock price is overvalued or undervalued.
Find the price-to-earnings ratio, which is widely published for individual stocks and broader markets on Yahoo! Finance, MSN Money and other financial websites. The P/E ratio of a stock is equal to the price divided by the earnings per share, which is the net income minus preferred dividends, divided by the number of outstanding shares.
Compare the P/E ratio of a stock to its industry peers and the overall market. A stock that is trading at a comparatively lower P/E ratio than its peers or the broader market could be undervalued, while a stock trading at a higher P/E ratio could be overvalued. However, a stock price might be low because the company is in serious financial trouble, reports John W. Schoen of MSNBC.
Evaluate the valuation of broad market averages. Yale professor Robert Shiller uses historical earnings of Standard & Poor’s 500 stocks to determine if the broad market is undervalued or overvalued. The S&P 500 is a broad measure of 500 large U.S. public companies. According to the Wall Street Journal, Shiller used this method to correctly predict the 2000 tech crash and the 2006 housing crash. A pricey market can still trade higher, but at least you can exercise some caution in your individual investment decisions. Similarly, a falling market can continue to fall before stabilizing and trending higher.
Consider both sales and earnings, suggests SmartMoney magazine columnist James B. Stewart in a February 2011 Wall Street Journal article. Earnings are important, but companies that demonstrate healthy year-over-year revenue growth are more attractive. He uses a P/E threshold of 14 to determine overvaluation or undervaluation. Companies that have higher growth rates, such as new technology companies, tend to have higher P/E ratios.
Assess the market sentiment. Scan through news stories and listen to stock analysts on various business media outlets to get a sense of it. Pervasive gloom and doom might indicate undervaluation, while a sky-is-the-limit euphoria could indicate overvaluation. However, research cited by Wall Street Journal reporter Jonathan Clements indicates that market timing is a risky strategy that rarely outperforms a patient buy-and-hold strategy.
Use technical analysis, which forecasts future price trends based on historical data. Relative strength index is a common technical indicator, which measures the speed and change of stock price movements on a scale of zero to 100. According to Bullseyestox.com, an RSI above 70 indicates overvaluation and an RSI under 30 indicates undervaluation. Yahoo! Finance, MSN Money and other financial websites provide free technical analysis tools.
- MSNBC; When Is a Stock ‘Undervalued’?; John W. Schoen; September 2003
- “The Wall Street Journal”; Is the Market Overvalued?; E.S. Browning; April 2011
- “The Wall Street Journal”; It’s Time to Focus on Revenues; James B. Stewart; February 2011
- “The Wall Street Journal”; After 13 Months of Plunges, Reasons to Return to Stocks; Jonathan Clements; May 2001
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.