If you want to start making money trading stocks, or take your trading game to the next level, you’ll need to learn how to analyze the value of stocks. All of the best traders are looking for the next undervalued stock to invest in, because this means that the value is likely to go up in the future, earning you cash. Finding companies that have sound fundamentals but that are valued lower than they’re worth is one of the best way to make money by investing.
When the value of the stock eventually goes up, as it’s likely to do, you’ll make money through dividends and future trades. Investing in undervalued stocks is therefore a great trading strategy to make money on the stock market.
To find undervalued stocks to invest in, you should:
- learn about why stocks become undervalued,
- focus on businesses you understand,
- assess the price-earnings ratio and the price-book ratio,
- check out the relative price performance,
- look at the price-earnings growth ratio,
- assess the market-to-book ratio,
- look at free cash flow,
- and finally, be patient.
Here, we outline some of our best tips for determining undervalued stocks. Studying the market can help you to learn how to identify stock trends and make money trading, so get started today.
What Are Undervalued Stocks?
If there’s one truism of trading stocks to score big, it’s ‘buy low, sell high.’ The concept sounds simple, but executing these kinds of trades can be more complicated than it seems. A low price doesn’t guarantee that a stock will eventually go up; in fact, it’s possible that the stock has been assigned it’s true value.
Rather, in order to maximize your profits, focus on identifying undervalued stocks and taking advantage of the gap between a stock’s value and its price.
An undervalued stock is a security that is selling at significantly below its intrinsic value. Here, we get in to our best tips for determining whether a stock is valued appropriately or undervalued, how to determine undervalued stock, and how to make money trading stocks with your new knowledge of how the markets work.
1. Learn About Why Stocks Become Undervalued
The first step in taking advantage of undervalued stocks to make money through trading is to understand more about why stocks become undervalued. Once you understand this, you’ll be better equipped to know if a stock is undervalued.
There are a few reasons why a stock could be undervalued. First, if an entire market crashes, there might be a gap in time before a share reaches its true value again. Second, if a particular company’s quarterly report falls short of expectations, the prices of its shares could temporarily drop.
Third, some sectors perform better or worse at different moments in the market cycle, so sectors that are currently out of favor may be undervalued. Finally, other types of bad news, such as an international crisis or change in regulations, can send a stock’s price down, sometimes temporarily, meaning that the stock is undervalued.
2. Focus on Businesses that You Understand
The next step is to hone in on businesses and sectors that you already understand. New investors sometimes get carried away and end up buying shares in companies where they don’t understand the underlying business model or know how a particular company makes its profits.
Looking at sectors that you’re already familiar with will help you to understand why a stock’s price may be undervalued, and why the share price could recover in the near-term future. In other words, your existing knowledge will help you to get at the company’s underlying fundamentals. Take advantage of what you already know!
3. Assess the Price-Earnings Ratio and the Price-Book Ratio
Next, there are a few metrics you should be familiar with in order to identify undervalued stocks. The price-earnings ratio, or P/E, is one of the most common measures of a stock’s relative value.
The P/E measures the ratio of the value of a company’s share price to the stock’s earnings per share. Essentially, this shows you how much investors are willing to pay to make back each dollar of earnings from ownership of a particular stock.
To calculate the price-earnings ratio yourself, locate a company’s balance sheet. You can usually find this in the company’s filings with the U.S. Securities and Exchange Commission (SEC), on the company’s website, or in its annual report. Next, take the company’s total profit over the past year, and divide that by the total number of shares.
Generally speaking, the lower the P/E ratio, the better a buying opportunity you’re facing. We recommend looking for a P/E ratio of 9 or less in order to identify stock that may be undervalued.
The price-book ratio, or P/B, is another great way to find undervalued stocks with simple math. The P/B ratio compares the stock’s current price with its book value, or the value of the stock in the company’s balance books, which in turn is based on a company’s liabilities and assets. To calculate the P/B ratio, divide the current price of the stock by the book value per share.
Investors usually look for a P/B ratio of less than one. A P/B ratio under one is usually a good sign that a stock is undervalued.
4. Check Out the Relative Price Performance
To identify undervalued stock, you should also be looking at the relative price performance.
Relative price performance measures a company’s stock price against its closest industry peers. If the company’s share price is significantly lower than its peers, that may suggest that it is undervalued.
One metric that measures relative price performance is relative performance. You can calculate relative performance by taking the Friday closing price of a stock, and dividing it by the Friday close of a stock index such as the S & P 500.
5. Look at the Price-Earnings Growth Ratio
A low price-earnings growth ratio is another good indicator that a share price may be undervalued.
The price-earnings growth ratio, or PEG, is usually an even better metric than the company’s P/E. That’s because the PEG takes into account a company’s expected future growth, as well as its current value.
To calculate the PEG yourself, take the P/E ratio, which you’ve already calculated, and dividing it by the stock’s ‘earnings growth rate.’
A PEG lower than one usually indicates that investors are taking past performance into account more than projections of future growth opportunities. This means that a stock may be undervalued compared to its potential future price.
6. Assess the market-to-book ratio
Assessing a stock’s market-to-book ratio is another great way to tell if a stock is undervalued.
The market-to-book ratio is also sometimes called the price-to-book ratio, and measures a company’s current market price compared to its book value. In other words, this metric shows the company’s available net assets in relation to the sale price of its shares.
A company with a low market-to-book ratio may be undervalued, since the value of the assets the company owns means that it could grow in the near-term future. If the market-to-book ratio of a company is low, this is usually and indicator that investors are not fully taking into account the value of assets that the company has on its books.
7. Look at Free Cash Flow
You should also take a look at a company’s free cash flow in order to understand whether its stock is potentially undervalued.
Free cash flow is the amount of cash that a company generates after the cost of expenditure on assets is accounted for. Many investors don’t take free cash flow into account, to their loss. A company could have lower reported earnings, leading investors to undervalue it, whereas a company could be doing much better in practice with regards to its free cash flow.
8. Finally, Be Patient
Finally, our most important tip for how to determine undervalued stocks is to be patient. Some new investors try to rush into an investment without assessing all of the fundamentals. Unfortunately, sometimes the market is simply expensive overall, and its much more difficult to find attractive bargains.
Undervalued stock will eventually come if you do your homework, but you need to be patient in the meantime. Don’t rush in to an investment that you’re not 100% sure about.
Learn more about how to identify undervalued stocks today from RagingBull. Finding undervalued stocks is just one of the many tricks of the trade that can help you make money through trades.
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