Guide to spotting and buying undervalued stocks

Contrary to common belief that only international and Singapore blue-chip stocks are worth buying, more savvy investors are looking out for undervalued stocks because of their intrinsic value, meaning they have room to grow in price as the market eventually recognises their true worth.

With a well-planned strategy, investing in these stocks can even ensure more efficient portfolio diversification since they help to spread risks and reduce the volatility of a portfolio over time.

If you have been investing or intend to invest in stocks that have potential for high returns, read on for a few essential tips on how to identify and buy undervalued stocks.

What are undervalued stocks

For a stock to be considered undervalued, it should be traded below their perceived value and has a potential for long-term profitable growth, which the general stock market may not recognise yet. This is like a stock selling for S$50, but it is worth S$100 based on predictable future cash flows.

However, spotting true-blue undervalued stocks with growth potential can be tricky because companies that appear to be undervalued can actually be in decline. Also, undervalued stocks may not always appreciate in value and remain that way for an extended period. This is why assessing stocks using value investing strategies and tips are of utmost importance to identify mispriced securities that are really worth investing.

Five value investing tips for spotting undervalued stocks

If you are ready to invest in undervalued stocks, you must be ready to go against prevailing market trends and only rely on technical assessments or financial metrics. Here are five strategies that can help you spot the best buy.

1. Study the price-to-earnings ratio and market capitalisation

A stock's price-to-earnings ratio is also known as PE ratio. It is commonly used as a valuation metric to compare a company's stock price to its earnings per share (EPS). When a company's stock has a low PE ratio, it signals the chance to buy the valuable stock at a discounted price. On the flipside, a higher PE ratio indicates overvaluation.

PE ratio = Current price / Most recent earnings per share

Besides the PE ratio, you may also want to look at the company's market capitalisation (market cap). This value offers an insight into the total value of a company's shares of stock and may reveal how profitable the company is.

Market cap = Current price of a single share x Total number of shares held by stockholders

2. Look into the price-to-book ratio

The Price-to-Book (PB) ratio is another important financial metric that investors use to assess the valuation of a company's stock. It compares the market price per share of a company's stock to its book value per share.

PB ratio = Market price per share / Book value per share

Typically, a ratio under 1.0 is considered a solid investment because it is a telltale sign that the market is under-pricing the stock, while a high PB ratio may suggest the stock is overvalued.

However, this ratio should be evaluated with the industry of the company in mind. Some companies in technology or service-based companies may have high PB ratios due to their reliance on intellectual property and intangible assets that are not accounted for by book value. As such, you should always assess the PB ratio alongside other metrics.

3. Watch for increased earnings

Is the company reporting steady growth and increased earnings in the last couple of years? If so, you may want to take the stock to the next level of analysis to determine if it is really worth investing. Companies reporting strong growth may still have a chance of reaching their peak and stagnating in the near future.

Besides using metrics like PB ratio for assessment, you may also look at the price-earnings to growth ratio (PEG) which compares PE ratio to the percentage growth in annual earnings per share (EPS). If the company has solid earnings and a low PEG ratio, it could mean that its stock is undervalued.

PEG ratio = PE ratio / Percentage growth in annual EPS

4. Sudden decline in stock price

How to spot and buy undervalued stocks without tedious analysis of various metrics? Start looking out for stocks that recently experienced sudden fall in prices by at least 20 per cent may present you with an initial list.

Bear in mind that security prices can drop for a variety of reasons that may not be directly related to negative growth of the companies. As long as your research on each company's fundamentals provide substantial justification for the decline in price, you may have spotted an undervalued stock.

If you prefer to buy Singapore stocks, you can refer to Sginvestors website for shares at a 52-week low. The site allows you to easily identify potential stocks that you can do further research before deciding if you should invest in them.

5. Analyse dividend yield and cash flow

When a company consistently pays a high amount of dividends, regardless of low share price, it is a sign that the company has strong financial backing and the stock may be undervalued. However, take note that a company offering a very high dividend may run the risk of having cash flow problems since funds are channelled into paying shareholders instead of growing the business or paying off debts.

Conclusion

Spotting undervalued stocks can be a tricky task unless you are using value investing strategies and tips to analyse the growth potential of shares. Instead of using a single financial metric to determine if you have correctly identified one, using a mix of metrics like PE ratio, PB ratio and dividend yield may offer more accuracy.

ALSO READ: How to pick dividend stocks for your portfolio

This article was first published in ValueChampion.