The eternal mantra of stock investing is to "buy low and sell high." And every day, millions of stock brokers and traders -- from professionals to armchair day traders -- try to do just that.
But how do they do it? How do they tell when a stock is undervalued enough to offer a chance at profit?
A good bit of it is luck (and maybe instinct). There's undeniably an element of right place, right time when it comes to profiting off the stock market. Yet there's also an art and, yes, a bit of science to it, as well.
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That is to say, there are a few common telltales of an undervalued stock. If you can understand why and how stocks become undervalued, you can potentially use these signs to find them on your own.
Understanding what makes a stock undervalued
When you buy a stock, you pay the current share price. That's the value the market has given that stock at a given moment.
The share price isn't always indicative of the actual value of that stock, however. Some stocks are considered to be overvalued, while others are undervalued.
There are a few reasons a stock isn't trading at its perceived value:
- Demand: If a stock is popular -- or has lost popularity -- demand could be unusually high or low, impacting the share price in a way that isn't congruent with the perceived value of the stock. (A good example here may be the so-called retail or meme stocks like AMC and GameStop.)
- Headlines: When a company makes headlines, their share price can be impacted. If those headlines are for the wrong reasons, their share price could drop below its perceived value.
- Reactions: The market can often be quite reactive. Investors may over or under react to certain news, like quarterly reports missing expectations.
- Speculation: A big part of investing is trying to predict the future. When investors think a company has a good potential for growth in the near (or even long) term, the stocks may become overvalued. But if the company's future is in question, the stocks could become undervalued.
Essentially, anything can impact the share price and value of a given stock. Markets are fickle, and any stock can become overvalued or undervalued.
Identifying undervalued stocks
Since undervalued stocks can come from any industry and any company, actually spotting them in time to profit off them can be tricky. Here are a few tips from experts on how to find them.
Stick with what you know
Identifying undervalued stocks relies in large part on accurately valuing the stock to begin with. If you don't know anything about the industry or company in question, it'll be next to impossible for you to accurately value the stock.
For example, if you don't know much about the auto industry, you'll probably lack the background knowledge needed to guess if that niche electric car company has a bright future -- or a dim one. And you'll probably want at least some knowledge of the energy sector before you try to evaluate that solar panel company.
Crunch the numbers
There are a lot of various metrics used to value companies and stocks. Here are just a few to know about when looking for undervalued stocks:
- Price-to-earnings (P/E) ratio: This is the stock's current share price divided by its annual earnings. A low P/E ratio could be a sign that a stock is currently undervalued.
- Price-to-book (P/B) ratio: This is the stock's current share price divided by its equity per share (which is based on the company's assets). A low P/B ratio could indicate an undervalued stock.
- Earnings per share (EPS): This is a company's profit divided by its outstanding shares of common stock. A high EPS tends to indicate a more profitable company.
- Return on equity (ROE): This is a company's net income divided by the equity held by shareholders. This is a way to measure the company's return on net assets, or how well it's using its invested capital. A high ROE tends to indicate a more efficient company.
Dig into the company
As we went over in the previous section, there are a lot of reasons a company's share price can be different from its perceived value. And many of those reasons aren't as easily quantifiable as we may like.
So, go beyond the math. Look at the industry, the company, the headlines, and the employees. Any and all of these can provide key information for valuing a company.
For example, are people within a company buying up a lot of its stock? That could be a sign that they think it has a lot of value. And they may know better than those looking from the outside, in. On the other hand, if everyone is selling shares and fleeing -- that could be a sign of trouble to come.
Predicting the future comes with risks
No matter how much information you dig up and how many numbers you crunch, there's always going to be risk inherent in trying to predict the future of any stock. While there can also be a lot of rewards to correctly picking an undervalued stock, you need to weigh your own risk tolerance.
So, while it's perfectly fine to try and find the next big stock, be smart. Don't be unnecessarily risky with, say, your retirement funds.
What I like to do is keep a separate investment account for playing. It's this account that I use when I want to trade individual stocks or follow an investment hunch. At the same time, my retirement funds are resting comfortably in a separate IRA where they can continue to grow, slow and steady.
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