A truly undervalued stock is not easy to find and this remains a common knowledge. In most cases, the stocks would have reflected both the good and bad news affecting the stock or the issuing company into the stock price.
However, market may occasionally miss-price a stock as a result of emotional reaction from retail players. The question then arises as to how we can detect the real hidden gems? You may use the indicators listed below as a guide to spot the good ones and avoid value traps.
Low Price To Book Value
A company with low price to book value may appear to be an undervalued stock. However, it may be not the case. It may be due to employment of aggressive accounting methods of capitalisation items instead of expenses in nature. Thus, it may lead to significant effects on the book value. Investors should therefore be cautious when trading stocks that appear as priced lower relative to their book values without consideration of high risk, poor potential growth and negative or low returns on their future projects, just like catching the falling knife.
The price-to-book ratio (or P/B ratio) is a good indication of what investors are willing to shell out for each dollar of a company’s assets. This ratio divides a stock’s share price by its net assets, less any intangibles such as goodwill.
To exclude intangibles is an important element of the price-to-book ratio as it reflects what investors are paying for real-world tangible assets, not the harder-to-value intangibles. Hence, the P/B is a relatively conservative metric.
This P/B ratio has its own limitations: especially for companies that have significant intangibles, the price-to-book ratio can be very misleading. However, generally any P/B of 1.5 or less is a good path to solid value.
Another possibility may be caused by the quality of their vested assets both tangible and intangible which they may have to write off in near future. One excellent example is of noise pollution restriction imposed by new regulations which may cause old aircrafts to be written off.
Close follow up and scrutinization on their corporate news pertaining to latest development of the main assets is necessary so as to detect those associated risks. Be mindful that the value of assets are grounded on the notion of historical cost (original cost) or book value; which are different from their fair market value! No doubt this value will then be either adjusted upwards for any subsequent improvement or downwards for the loss in value associated with the ageing of the assets, these treatments are applicable to fixed assets, namely land, building, ships, planes, plant and machinery. To say that the accountants are conservative in this aspect may be overrated.
On the other hand, current assets such as the inventory, accounts receivable and some marketable stocks are required to be stated at current market values, where provision for both doubtful debts and obsolete stocks are made for the reporting periods.
Low Price To Earning Ratio
A company’s low Price to Earning is likely one of the best-known fundamental ratios as a bargain stock. This ratio is derived by dividing a stock’s share price by its earnings per share to come up with a value that represents how many times investors are willing to shell out for each dollar of a company’s earnings. The ratio is important because it provides a simple measuring stick to compare valuations across companies. Generally, a low P/E is preferred.
One great shortfall of this ratio is that it isn’t as valuable as when you’re comparing companies across different industries. This is mainly because certain industries, especially high-tech stocks, tend to have much higher P/E than normal manufacturing companies. However, if you’re comparing apple to apple though, the P/E ratio can give you an excellent glimpse at a stock’s valuation.
More in-depth understanding of its business model, potential and accounting treatment is required to ascertain its risk with accuracy. This is mainly because many of the value traps seen over time have been characterised by dodgy accounts. In energy stocks, Enron for example; opaque accounts and a complex business model would prove to cover up the creative accounting fraud. It collapsed and went bust in December 2001. When the company is suspected of fraud, it is hardly a good idea to buy the stock, regardless of its price. That’s why the element of integrity is a crucial investment consideration.
Price/Earnings To Growth Ratio (PEG Ratio)
The ratio is a modified version of the P/E ratio that also takes into account earnings growth which reflects a better picture of its valuation. Hence, their PEG ratios can be a relatively better way to find companies that are undervalued yet growing, and likely to be more attractive amongst investors. Like the P/E ratio, this indicator varies from industry to industry.
Enterprise Value/Earning Before Income Tax, Depreciation & Amortisation
Enterprise Value (EV) by EBITDA is often used with the P/E ratio to value a company. EV is market capitalisation plus debt minus cash, which gives a much more accurate takeover valuation net debt. The main advantage it has over the P/E ratio, is that it can be skewed by unusually large earnings driven by debt.
EBITDA is earnings before interest, tax, depreciation and amortisation. This ratio is used to value companies with huge debts. The main benefit of this ratio is that it can be used to evaluate companies with different levels of debts as its capital structure.
A lower ratio indicates that a company is undervalued. It is worthy to note that the ratio is high for fast-growing industries and low for industries that are growing slowly.
Return On Equity (ROE)
ROE is the ultimate measure of the return to shareholders from the business and overall earnings. It helps investors compare profitability of companies in the same industry. This ratio reflects the capability of the management. ROE is net income divided by shareholder equity.
ROE of 15-20% is generally considered good, though high-growth companies should have a higher ROE. To ensure a higher growth rate, the company needs to reinvest all or part of it’s earnings to maintain or generate a higher ROE. However, a rise in debt will also reflect in a higher ROE if wisely employed.
This is dividend per share divided by the share price. Generally, a higher figure signifies that the company is performing well. Caution should be on those penny stocks (that lack quality but have high dividend yields) and companies especially benefiting from one-time gains or excess unused cash, which may used to declare special dividends.
Similarly, a low dividend yield may not necessary imply a bad investment as companies may choose to reinvest all their earnings so that shareholders earn good returns in the long term.
A high dividend yield, however, could signify a good long-term investment as companies’ dividend policies are generally fixed in the long run.
Going Beyond Numbers
When it comes to investing, investors need to look beyond the numbers as numbers aren’t everything. Other qualitative aspects like management quality, macro-economic situation and industry outlook should also be studied in detail. A cheap stock doesn’t necessary mean that it deserves to increase in value.
Ultimately, to enhance your fundamental analysis skills, there is no other way than to put them into practice coupled with appropriate mindset. With the above fundamentals under your belt, you’re better equipped to finding the most undervalued stocks in the market.