What are Undervalued Stocks?

There’s a big difference between undervalued stocks and cheap stocks. Here’s how you can tell the difference.

If there’s one thing every investor has in common, it’s that we’d all like to find those perfectly undervalued stocks at rock-bottom prices and scoop them up. We’d love to hold them as they increase astronomically in value, securing our retirement in the process. 

The truth is that there are plenty of cheap stocks out there. And there are undervalued stocks, as well. But rarely are they the same thing. 

Value stocks are most often quality companies where capable management is working hard to build value. Sometimes there are issues that cloud the near-term story but will likely be remedied. In others, the companies are hidden among less interesting industry peers. Occasionally, the market is waiting for several quarters to pass following a transition (new CEO or spin-off, for example). In other words, you need patience to make a profit with these stocks. 

Four components will help you identify value stocks:

1. Earnings per share (EPS) growth: Over the medium and long term, earnings growth drives share price growth. The stock that’s most likely to rise is the stock with growing earnings. 
2. Price/earnings ratio (P/E): The stock’s current P/E should be lower than the EPS growth rate.
3. Dividend yield: A long-term dividend payout is almost always a good sign. 
4. Long-term debt-to-capitalization ratio: Simply put, high debt levels can strangle a company’s ability to invest, innovate, and compete.

One last word of advice: Always find out why a stock is selling at a bargain price before investing. Is the company competing in an industry that is dying? Is the company suffering from a setback caused by an unforeseen problem? The most important question is whether the company’s situation is short-term or long-term and whether management is aware of the problem and taking action to correct it. 

To learn more and discover how you can find the right stocks for your portfolio, download our free report, How to Find Undervalued Stocks – Plus the Benjamin Graham Approach to Value Stocks, right now.