If you could buy a $100 bill for $80, wouldn’t you jump at the chance? I know I would.

Wouldn’t it also be nice if we could just walk up to the clearance section of a stock market superstore and pick out all the undervalued stocks that we liked best?

Unfortunately, value investing doesn’t quite work like that…

While a little more complex, value investing embodies the general idea of buying a $100 bill that’s been discounted to $80.

Finding the best stock market bargains can be tough, but these tips can get you started…

What Is Value Investing?

Value investing is the art of identifying undervalued stocks.

The Motley Fool defines value investing:

Value investing consists of investing in stocks trading at prices below their intrinsic value. Value investors, therefore, are essentially buying stocks at a discount to what they believe they are worth, in hopes these investments will eventually rise to reflect their intrinsic value.

Value investors understand that the market often undervalues stocks based on news and events that have little if anything to do with the long-term fundamentals of those stocks.

And they apply specific strategies to identify and invest in such stocks…

Understanding How Stocks Become Undervalued

When you buy a stock, you want to evaluate if its current price is higher or lower than what it’s worth over the long term.

All sorts of events that have nothing to do with a stock’s intrinsic value can affect its price, and frequently, this means stocks are undervalued.

One of the central ideas of value investing is that the market misprices stocks from time to time.

There are many reasons as to why a stock may become undervalued, but these are a few of the most common ones:

• Missed expectations. If a stock reports quarterly results that fall short of expectations, shares can drop more than the situation calls for.

• Market crashes and corrections. When the entire market drops, it’s a great time to look for undervalued stocks.

• Bad news. Just like when a stock misses analysts’ expectations, bad news items can cause a knee-jerk response, sending shares plunging more than they should.

• Cyclical fluctuations. Certain sectors tend to perform better at different stages of the economic cycle. Sectors that are out of favor are good places to look for bargains.

The Art of Value Investing

The key to buying an undervalued stock is to thoroughly research the company and not just buy a stock because a few of its ratios look good or because its price has recently dropped.

It’s not quite that simple to tell if a stock is a good buy. But applying your own common sense and critical thinking are absolutely essential skills in stock selection.

Only consider businesses you understand — this should go without saying.

Too many investors often buy shares of companies without really knowing how the businesses make their money or without having a grasp on the overall dynamics of the industry.

So, as another rule of thumb, I highly recommend narrowing your search parameters to only include businesses with structures you understand.

Another strategy that value investors favor is to buy companies with products or services that have been in demand for a long time and are likely to remain in demand.

Looking at stock quotes won’t tell you what companies these are — you’ll have to do some critical thinking in order to identify them.

Of course, it isn’t always possible to predict when innovation will make a longstanding product or service obsolete, but we can find out how long a company has been in business and research how it has adapted to change over time.

It may also be worthwhile to analyze the management and the effectiveness of corporate governance to determine how the firm reacts to changing business environments.

Now, let’s discuss how to use the information provided in a company’s financial statements in order to find the best undervalued stocks…

How to Evaluate Stocks: The Graham Model

J. Royden Ward, an experienced value investor, developed a computerized value investment stock-selection model in 1969 based on the investment strategies of Warren Buffett and his mentor Benjamin Graham.

Ward lays out the criteria for value stock selection based on Graham’s theories, as summarized by Business Insider:

1. Quality rating

Ward recommends looking at stocks with a quality rating that is average or better. Like Graham, he advises using Standard & Poor’s rating system to find out stocks with an S&P Earnings and Dividend Rating of a B or better… To be safe… it’s best to choose stocks with quality ratings of at least B+.

2. Debt to current asset ratio

In value investing, it’s important to select companies with a low debt load… You should select companies with a total debt to current asset ratio of 1.10 or less. There are a number of services which supply total debt to current asset ratios, including Standard & Poor’s Value Line.

3. Current ratio

The current ratio provides a good indication of how much cash or current assets a company has—something that demonstrates they can weather unanticipated declines in the economy. You should buy stocks from companies with a current ratio of 1.50 or higher.

4. Positive earnings per share growth

To avoid unnecessary risk, value investors look for companies with positive earnings per share growth. Specifically, you should examine this metric over the past 5 years, and prioritize companies where earnings increase over that time period. Above all, avoid companies which posted deficits in any of the last 5 years.

5. Price to earnings per share (P/E) ratio

You should select stocks with low P/E ratios, preferably 9.0 or less… This criterion eliminates high growth companies, which, according to Ward, should be assessed using growth investing techniques.

6. Price to book value (P/BV)

P/E values are helpful, but they should be viewed contextually. Specifically, you also need to consider the current price of a stock in relation to its book value, which gives you a strong indication of the underlying value of the company. As a value investor, you want to invest in stocks which are selling below their book value. The P/BV ratio is calculated by dividing the current price by the book value per share.

7. Dividends

You should look at companies which are paying steady dividends. Undervalued stocks eventually tick higher as other investors figure out they’re worth more than what their price suggests, but that process can take some time. If the company is paying dividends, you can afford to be patient as the stock moves from undervalued to overvalued.

The criteria that Ward suggests provide a useful strategy for identifying and investing in undervalued stocks. But it’s also important to understand the underlying conditions within a company that are the causes of its bargain price.

For example, a stock might be undervalued because the company is part of a dying industry.

If a company is experiencing a problem that is the root cause of its undervaluation, the key is to discern whether the problem is short or long term and if the company’s management has a sound plan to address it.

The Bottom Line: A Final Rule

The final rule for finding the best undervalued stocks is to be patient.

Sometimes, the overall market gets expensive and none of the companies you follow seem to be trading at attractive values, and this is completely okay.

Bargains will resurface. So, if you can’t find an undervalued stock, don’t force an investment that you may later regret…

That’s all for now.

Until next time,

John Peterson
Pro Trader Today