With any expensive purchase, your ultimate goal is to get your money’s worth and something whose value would increase over time—like jewelry, property, or stocks. And the deal always becomes better when you get it at a discount. If you apply this to the world of investments, you’d be talking about undervalued stocks.

For an investor, the ultimate goal is to find stocks that will appreciate over time, and one strategy to achieve this is to identify undervalued stocks. These are shares trading at a price lower than their intrinsic value, meaning they are potentially worth more than their current market price. If you invest in undervalued stocks, you can benefit from the power of compounding over time, as your initial investment’s growth will generate additional returns.

Here’s a lowdown on undervalued stocks, how to identify them, and things to remember before investing in them.

What are Undervalued Stocks?

Undervalued stocks are those whose current market price is lower than their intrinsic or true value. In simpler terms, they’re stocks trading at a discount compared to their worth. Investors often seek out undervalued stocks because they believe they can generate bigger returns as the share price rises to reflect its true value.

However, the key is to differentiate between undervalued and cheap stocks. A cheap stock might have a low price per share, but it might also be a poor investment. Undervalued stocks, on the other hand, are cheap because the market has mispriced them. They have solid fundamentals and growth potential, making them attractive investments. So, investors must ensure they are investing in undervalued stocks, not random cheap stocks.

How to Find Undervalued Stocks: The Power of Stock Screeners

If you want to buy undervalued stocks, you must know more than what the stock market is and how to trade or invest in it. You can rely on a powerful tool called stock screeners. These online platforms allow you to filter through thousands of shares based on various criteria, including the price-to-earnings ratio, dividend yield, and market capitalization. Setting specific parameters allows you to narrow your search to find stocks aligning with your investment goals.

Stock Screeners Explained

Stock screeners may have slightly different parameters, but most offer a core set of features. These typically include:

• Fundamental analysis examines a company’s financial statements, which include its income statement, balance sheet, and cash flow statement.
• Technical analysis: This involves analyzing historical price data to find patterns and trends of future price movements.
• Market capitalization: A company’s outstanding shares’ total market value.
• Dividend yield: A company’s annual dividend divided by its share price.
• Price-to-earnings ratio (P/E): Calculates a company’s share price relative to its earnings per share.
• Price-to-book ratio (P/B): Compares a company’s share price to its book value per share.

Eight Ratios to Spot Undervalued Stocks

Traders and investors typically use eight main ratios to identify undervalued stocks:

1. Price-to-Earnings Ratio (P/E): This ratio compares a stock’s price to its earnings per share. A lower P/E ratio suggests that the stock might be undervalued.
2. Debt-Equity Ratio (D/E): This ratio measures a company’s debt levels relative to its equity. A lower D/E ratio indicates a stronger financial position.
3. Return on Equity (ROE): This ratio measures a company’s profitability relative to its equity. A higher ROE suggests a more efficient use of capital.
4. Earnings Yield: The inverse of the P/E ratio and represents the percentage of earnings a stock pays out to shareholders. A higher earnings yield can indicate a potentially undervalued stock.
5. Dividend Yield: Annual dividend paid by a company divided by its stock price. A higher dividend yield can signify a stable and undervalued stock.
6. Current Ratio: A company’s ability to pay its short-term liabilities with its current assets. When the current ratio is greater than 1, it’s considered healthy.
7. Price-Earnings to Growth Ratio (PEG): This ratio adjusts the P/E ratio for a company’s expected earnings growth rate. A PEG ratio below 1 might suggest that the stock is undervalued.
8. Price-to-Book Ratio (P/B): This ratio compares a stock’s price to its book value per share. A P/B ratio below 1 can indicate that the stock is undervalued.

Things to Keep in Mind When Using Stock Screeners

While stock screeners can be valuable tools, remember they don’t work like magic. Here are some things to keep in mind while identifying undervalued stocks on stock screeners:

Qualitative factors: Consider factors beyond financial ratios, such as a company’s management team, industry trends, and competitive landscape.

Company-specific research: Always thoroughly research any company you’re interested in investing in.

Diversification: Don’t rely on only one investment instrument; diversify them across different sectors and companies.

Risk tolerance: Be clear about how much risk you can take and invest accordingly.

Conclusion

Using stock screeners can be a powerful way to identify undervalued stocks. However, using them along with other investment strategies and conducting thorough research on potential investments is important. Understanding the key ratios and factors to consider will enable you to find profitable investment opportunities.