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How to Find Undervalued Companies

Undervalued companies - How to Find Undervalued Companies

How can investors find high-returning, undervalued companies? With thousands of stocks available on investment platforms and trading apps, it’s hard to know where to begin.

But let me tell you this. Even YOU can beat the experts at their own game.

That’s because, by choosing companies that are cheap relative to their growth, you can outperform even some of the best professional fund managers. Studies have shown that skillful investors can do better by 8% per year.

Over a lifetime, that’s a massive difference. An average investor earning 5% returns would turn $5,000 annual savings into $604,000 over 40 years. A skillful investor outperforming by 8% annually turns that same $5,000 into $5,068,500.

So how can you get started? Here are five metrics that can help you identify significantly undervalued companies.

5 Ways to Find Undervalued Companies

To build a diversified portfolio, investors need a superior way to compare firms across many industries. At InvestorPlace.com, our analysts use various metrics to find great ideas. Louis Navellier’s Portfolio Grader, for instance, considers eight areas in creating a company quantitative scorecard.

And you can do that too. So, to get you started, here are five metrics that can help you quickly identified if a company has high investment potential.

1. Price-Earnings Ratio

PE Ratio ForumlaEarnings per Share = Net Income / Shares Outstanding

The price-earnings ratio is one of the most used formulas in the investment world. To calculate it, investors take the stock price and divided by its earnings per share. The smaller the number, the better. (Investors should typically target companies with a P/E of 30.0 or lower)

The P/E ratio is particularly useful for warning investors about overvalued markets. Before the 1999 tech bubble burst, the P/E ratio of American companies averaged 44. By the bottom of the 2008 crisis, the average had fallen to just 15. Investors who saw that opportunity would have quadrupled their investment in the S&P500 index.

The P/E ratio is incredibly powerful for its broad-based use. All companies report some form of earnings, whether positive or negative. That means you can use the P/E ratio to compare any company from asset-light software outfits to asset-rich manufacturing firms.

There is a downside, however. The P/E ratio doesn’t consider other factors, such as growth rates, financial risk, or net asset value. That means investors should use the P/E ratio in conjunction with other metrics as well.

2. PBV Ratio

Price to Book Formula

Book Value per Share = (Assets – Liabilities) / Shares Outstanding

The Price-to-Book ratio (PBV) is P/E’s traditional counterpart. The formula takes a company’s price and divides it by the book value (equity) of a company. The ratio is an ideal measurement of financial companies and other large-balance-sheet firms.

In the 1980s, Warren Buffett and other investors popularized PBV investing through “cigar-butt” investing. The theory (and practice) was that investors could buy up distressed companies selling at a PBV of less than 1.0. Investors could then liquidate the company’s assets, pay off its debt, and have more than enough left over as profit.

More recently, the PBV ratio has found its place in bank and insurance valuation. During the 2008 financial crisis, Citibank’s PBV ratio dropped to 0.12x. Investors jumping in at the right time would have seen their investments grow almost 600% that year.

3. Dividend Yield and FCF Yield

Dividend Yield Formula

Older investors often use a company’s dividend yield as a measure of cheapness. For example, a company with a stock price of 100 that issues an $8.00 annual dividend has an 8% dividend yield. Typically, any company with higher than a 5% dividend yield is considered a good value.

Free Cash Flow Yield FormulaFCF per share = (Cash Flow from Operating Activities + Interest Expense – Tax Shield – Capital Expenditures) / Shares Outstanding

However, companies have slowly moved away from issuing dividends, since the payouts get taxed at higher ordinary income rates. Instead, firm bosses have turned to share buybacks. That increases share prices, avoids the dividend tax, and allows investors to pay lower capital gains rates.

In response to dividends’ declining popularity, financial analysts have turned to a more comprehensive metric, known as free cash flow (FCF) yield. Not only does the formula consider dividend yield. It also adds the cash available for share buybacks and retained earnings.

4. PEG Ratio

PEG Ratio

Fast-growing companies often have higher PE ratios, making them look expensive and causing investors to miss out. By including a growth metric, investors can see whether a company can eventually “grow” into its high PE ratio.

“I would focus on the PEG ratio, or P/E ratio divided by the projected growth rate of earnings per share,” Clinical Professor of Finance David Kass at the University of Maryland’s Robert H. Smith School of Business wrote on investing. “The lower the PEG ratio, the more attractive (or undervalued) a stock is.”

For example, a company with a 40x P/E ratio might seem expensive at first. But if the company doubles its profits every year, its PE ratio will drop to 20x in Year 1 and then to 10x in Year 2.

By accounting for growth, PEG ratios can help investors identify companies that are “good-value-for-growth.”

5. EV/EBIT

EV-EBIT Ratio FormulaEnterprise Value = Market Capitalization + Preferred Equity + Market Value of Debt + Minority Interest – Cash & Investments

Operating Earnings = Net Income + Interest Expense + Taxes

EV/EBIT, or enterprise-value-to-EBIT, compares a company’s enterprise value with EBIT (earnings before interest and taxes). EBIT is also known as operating earnings.

In his 1980 best-selling book, “The Little Book That Beats the Market,” hedge fund manager Joel Greenblatt uses EV/EBIT as one of his two essential metrics to value companies. The other one, return on invested capital (ROIC), measures a company’s profitability.

It’s one of the most potent valuation metrics used by financial analysts. That’s because, unlike the PE ratio, the formula accounts for a company’s risk. Highly indebted companies will score worse under the EV/EBIT ratio since investors add debt back when calculating fair value.

The EV/EBIT formula also provides an improvement over another commonly used metric, EV/EBITDA. “References to EBITDA make us shudder,” famed investor Warren Buffett wrote in the 2010 Berkshire Hathaway annual letter. “Does management think the tooth fairy pays for capital expenditures?” EBIT, on the other hand, calculates depreciation and amortization charges that might otherwise go unnoticed.

Conclusion: How to Find Undervalued Companies

If this seems like a lot of information, don’t worry. The more you practice, the better you’ll get at finding these undervalued companies that can boost your portfolio. Our free tool, Louis Navellier’s Portfolio Grader, can help you get started in finding fast-growing companies at great value.

And if you’re looking for more help, you’ve come to the right place. Contact us today to receive our free daily newsletter for timely investment ideas and market commentary.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.


Article printed from InvestorPlace Media, https://investorplace.com/how-to-find-undervalued-companies/.

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