How to find undervalued stocks

A stock is cheap when its price is low next to its earnings or its assets. A stock is undervalued when its price is low next to what the business is actually worth.

Those are different things. A company with shrinking sales and rising debt can have a P/E of 6 and still be overpriced, because next year's earnings will be smaller. A great business with a P/E of 25 can be undervalued, because its earnings keep growing.

So the question is never “is it cheap?” It is “is the price below what this business is worth?” To answer that, you need two things: a business worth owning, and an estimate of its value.

Run a screen for low P/E stocks today and look at what comes back. A lot of it is companies whose best years are behind them, like shrinking retailers, businesses buried in debt, or companies whose last good year was a one-off.

The market is not always right, but it is rarely that lazy. When a stock looks cheap on one ratio, there is usually a reason. Finding that reason takes work, and a cheap-first screen has you doing that work on the weakest names first.

Value investors call these value traps: stocks that look cheap and stay cheap, or get cheaper. Our guide on how to tell a cheap stock from a value trap shows the warning signs side by side.

Step 1: Screen for quality first

Before you look at a single price, ask which businesses are worth owning at all. Check the last ten years, not the last quarter:

• Return on invested capital. How much profit does the business earn on the money put into it? Great businesses clear 15% year after year.
• Growth. Are earnings per share, revenue and free cash flow growing? Steady beats spectacular.
• Debt. Could the company pay off its long-term debt with about three years of earnings?
• Consistency. Ten good years, with no gaps to explain away.

Most companies fail this. That is the point. You are left with a short list of businesses you would be happy to own for a long time. The four pillars of a quality stock explains each check.

Step 2: Estimate fair value for each one

Now work out what each business on your list is worth. This number is called fair value, or intrinsic value.

The simple, honest way: take the earnings the business makes, guess how fast they will grow, and ask what that stream of future earnings is worth today. That is a discounted cash flow. The DCF for beginners guide walks through it with a worked example.

Two rules keep the estimate honest:

• Base growth on the company's own ten-year record, not on analyst forecasts.
• Cap it. No company grows 25% a year for a decade. Assume no more than about 15%.

Your number will be an estimate. Two careful people will get different answers from the same filings. That is normal, and it is why the next steps exist. What is intrinsic value? covers the idea in more depth.

Step 3: Compare the price to fair value

Only now do you look at the price.

If the price is above fair value, the stock is not undervalued, however good the business is. Put it on a watch list and move on.

If the price is below fair value, you may have found one. But “below” is not enough yet.

Step 4: Ask for a margin of safety

Your fair value will be wrong by some amount. You don't know how much, or in which direction. So you don't buy at fair value. You buy at a discount to it. That discount is your margin of safety.

• A stable business with a long, steady record: 25% to 40% below fair value.
• A business that is harder to predict: 50% or more.

So a stock is undervalued enough to buy when its price is below fair value minus your margin of safety. The margin of safety guide has the formula. What price to pay for a stock turns it into a single buy-below price.

Step 5: Ask why it is cheap

A great business doesn't trade below its value for no reason. Before you buy, find the reason. The usual ones:

• The whole market fell, and good businesses got sold along with bad ones. This is the best reason of all.
• Its industry is out of favour, and a sector sell-off dragged strong companies down with weak ones.
• It had one bad quarter, and the market overreacted to short-term news about a long-term business.
• Nobody is looking. Smaller, boring companies get less attention.

If the reason is temporary, and the ten-year record still holds, you may have found what you were looking for. If the reason is that the business is getting worse, go back to step 1. It no longer passes.

Sometimes you don't want a list. You have one company in mind and want to know if it is undervalued right now. Ask three questions, in this order:

1. Is the business any good? (Step 1.)
2. What is it worth? (Step 2.)
3. Is the price far enough below that? (Steps 3 and 4.)

That is the whole check. We ran it on Apple, with real numbers, in Is Apple undervalued? A five-minute check.

You don't need a secret list. Undervalued quality stocks tend to show up in the same places:

• Market sell-offs. When everything drops, quality drops too.
• Sector slumps. When one industry is out of favour, its best companies get priced like its worst.
• Boring businesses. Companies that make unglamorous things get less attention and fewer analysts.

The best source is your own watch list. Do the quality and fair value work once, ahead of time. Then when a sell-off comes, you already know which prices you are waiting for.

Doing all five steps by hand works. It is also slow. Checking ten years of numbers and building a fair value for one company can take an evening. Doing it for a whole market takes months.

Wonderfolio does the first four steps for you. It runs the quality check on ten years of each company's numbers, estimates fair value from the company's own track record, and derives buy, watch and sell zones from that fair value. Then it flags when a price crosses into a buy zone. The zones come from the numbers, not from a setting. Step 5, and the decision, stay with you.

Want to see one company run through it? The free report does it for a US or Canadian stock you choose. Or work it out by hand with the free calculators. The method is the same either way.