Earnings season is in full swing but as the summer season closes out, the usual lull in market activity is expected. However, that doesn’t mean you should let yourself fall into complacency when it comes to managing your portfolio. If you haven’t already, take a look at Forbes’ initial coverage on value stocks. In this article, we’ll break down how to define an undervalued stock, how to find one in a sea of possibilities, and then give a few examples for readers. Let’s dive in!
What Are Undervalued Stocks?
Defining whether a stock is undervalued or not is easier than you might think. A stock can be considered undervalued when its determined price is higher than the agreed-upon price. In practice, the “determined” price is the calculated intrinsic value of the stock (we’ll get into how to calculate this in a moment) and the “agreed-upon” price is the market price or what the public set of investors is willing to pay for the stock in the open market. Of course, there are mitigating factors that determine whether a given definition successfully encapsulates what “undervalued” means, but pragmatically, this definition should be sufficient for most investors.
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How To Find An Undervalued Stock
Depending on who you ask, price discovery in the modern stock market has either never been easier or is close to impossible now. The majority of investors have easy access to the necessary data and applications to perform their own valuations. Stock screeners come as part of many investing accounts and plenty of financial media sites include information feeds from providers like CapitalIQ as part of their subscriptions. But despite this access, investors still need to understand the financial basis for how to wield these tools in the quest for finding undervalued picks. A few of the key metrics that many investors choose include price/sales, price/earnings, price/book value, price/funds from operations, enterprise value/Ebitda, free cash flow and net asset value. Let’s take a look at each briefly:
Price/sales (P/S): A classic ratio that compares a company’s current share price with its revenue number (sometimes referred to as topline sales or turnover). A company’s revenue number is typically straightforward and easy to understand, so using P/S is a great starting point for investors new to performing their own valuations. This ratio is also great for analyzing companies that are pre-earnings, although this applies more to growth picks rather than value picks.
Price/earnings (P/E): Another of the most common metrics used by investors, the P/E ratio is so widely used that an investor can open up almost any finance application or platform and likely find this as one of the basic pieces of company information. It’s based on the company’s share price over its earnings number, which is commonly known as net income. On one hand, when a company has positive earnings, it is usually a sign of good health. However, because there are so many line items in-between its revenue and its net income, the earnings value can also be potentially manipulated. This isn’t that common, but it is something you should be mindful of when performing fundamental analysis.
Price/book (P/B): Rounding out the more popular metrics used by investors is the price/book ratio, which is simply a company’s share price versus the book value of its equity (determined by subtracting the company’s liabilities line item from its assets). As with the previous two ratios, the utility of P/B is driven by its simplicity and straightforward application as part of an analysis. However, P/B is usually only useful when looking at companies with large capital outlays. It may also not be of much use if an investor is analyzing a company with a balance sheet carrying a large amount of intangible assets.
Enterprise value/Ebitda: This metric is a bit more uncommon, although it’s great for investors who are looking to expand their analysis skill set. Enterprise value is a company’s total market capitalization plus its debt minus its cash and cash equivalents. “Ebitda” stands for earnings before interest, tax, depreciation and amortization; this is considered a useful metric because it focuses more on what a company generates purely from operations. However, Ebitda ignores capital costs so it’s not always a good fit. Still, if used in the proper context, this ratio can have good utility. Typically, analysts use this metric for comparing companies that are highly similar and for locating possible M&A targets that could have their share prices bid up.
Calculating Implied Share Price
Investing can be daunting for many reasons, but the quantitative aspect can seem like the tallest mountain to climb. Luckily, simple algebra is really all that’s needed for basic financial analysis. Before we share a few undervalued picks, let’s take a moment to review how investors can use valuation metrics based on ratios to calculate their own implied share prices. An undervalued, fairly valued or overvalued judgment can also be made using a similar approach. We’ll take a moment here to build a hypothetical scenario to help illustrate both these efforts:
- Company A is currently trading at $10 a share and its most recently reported earnings per share (EPS) was $2
- This gives us a P/E of 5 ($10/$2)
After reviewing hypothetical Company A’s historical data, we note that it has maintained an average P/E of 5 in the last few years. By comparing the current P/E with this historical value, we can draw the conclusion that Company A is currently fairly valued since these P/Es are the same (also note that because they’re identical, there’s no need for calculations). Moving on:
- Company A releases new earnings and reports an updated EPS of $3, but the market responds mildly and the share price only moves to $12
- Our new P/E calculation is now $12/$3, which equals a P/E of 4
Assuming that the company should trade at its historical P/E value of 5, we can now calculate an implied share price:
- P represents the implied share price that we want to calculate
- Our equation will look like this: P/$3 = 5 (this should be familiar since this is just the usual P/E ratio!)
- Multiply both sides by 3 to get X = $3 * 5, which gives us $15
Therefore, our implied share price for Company A is $15. We can go a little deeper and derive that the share price is 20% undervalued through the following steps:
- We can compare the starting and ending values by using the equation (A/B) – 1 = C, with C representing the change between the two values,
- Assume that a negative value means the stock is undervalued, anything close to zero is fairly valued, and a positive value means the stock is overvalued
- Plugging in our starting and ending share prices gives us ($12/$15) – 1 = -0.20
- Therefore, Company A is undervalued
That wasn’t so bad, right? Hopefully, this illustrates how a bit of math and a clear, confident gameplan can help you become a more savvy investor. Now, let’s move on to a few real-world examples of undervalued stocks.
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List of Most Undervalued Stocks Right Now
Here are our top three picks that are currently undervalued:
- Disney (DIS)
- NextEra Energy (NEE)
- Keurig Dr Pepper (KDP)
Disney (DIS)
Disney continues to be a popular stock thanks to its powerful branding, overwhelmingly popular parks and veritable treasure trove of intellectual property. To borrow a phrase from legendary investor Peter Lynch, Disney is a classic stalwart pick. This essentially means that while it won’t blow you away with its growth rate or return over time, it can form the bedrock of most long-term portfolios. It’s currently trading at a P/E of 72, which is quite elevated in a general sense, but lower than the company’s historical average since 2021. While generally a reliable pick, keep in mind that even a venerable company like Disney can find itself dealing with adverse events. Currently, the company is embroiled in a legal battle with Ron DeSantis, the current governor of Florida. This topic goes beyond the scope of this article, but I’m mentioning it because it can potentially create an unexpected impact on Disney’s share price. Although difficult to do, consider factoring this situation in when determining its valuation. For those wanting to follow the stock, here are a few key drivers to use as inputs in your model:
- Disney+ subscribers
- Annual park visits
- Merchandise sales
NextEra Energy (NEE)
A list of value stocks wouldn’t be complete without at least one utility name and NextEra Energy fits the bill. Another Florida-based company, NEE has both the staple of consumer electricity delivery alongside green energy projects. The former provides consistent predictable cash flows while the latter offers a sort of “future-proofing” to the company’s operations. NEE released earnings on July 25, beating on both EPS and revenue. The company has beat on EPS for several quarters in a row now, an indication of its financial strength. Looking at NEE’s P/B suggests a fairly significant premium, given that it’s at 3.1 at the time of writing. However, this metric was at 4.9 on December 31, 2021, which shows that NEE is undervalued relative to its historical P/B. Earnings have been steadily climbing since 2020, so while there may be concerns about NEE’s heavy cost related to acquisitions and green energy investments, now looks like a good time to buy in. A few drivers to consider when modeling NEE include:
- Average temperature in Florida
- Total customer count
- Capital expenditures
Keurig Dr. Pepper (KDP)
Consumer staples are typically a good place to look for undervalued stocks. Keurig Dr. Pepper presents a potential pick for those interested in this sector. The best way to think about KDP is as a beverage company: the name captures both of its key products, both of which should be familiar to the average consumer. Its P/E is currently at 30, which is lower than comparables like Monster Beverage (43) and PepsiCo (32), but slightly higher than Coca Cola (25). This illustrates two key points for investors: it’s easy to potentially cherry-pick comparables and argue “this stock is undervalued.” but also just because a data set isn’t perfect doesn’t mean your argument is immediately invalidated. While its debt levels could raise a few eyebrows, KDP has put up solid albeit lumpy earnings since 2019, so investors shouldn’t worry too much. Still, keep an eye on volume trends and the state of consumer spending, as both can impact modeling for this company. On that note, consider the following drivers when analyzing the stock:
- Beverage sales
- Price of coffee
- Federal funds rate
Bottom Line
Undervalued stocks are the bread-and-butter of most investors’ portfolios. The classic “buy low, sell high” phrase certainly applies, but it’s important to understand that a stock can be undervalued regardless of its classification of growth or value. Often, investors will encounter a cheap price relative to a given stock’s historical value, but a stock can also be a bargain versus its comparables. Metrics like P/B and P/E are classics that investors can rely on, but remember they’re not necessarily the best depending on the company that an investor is analyzing. Check the best practices for the sector and industry you’re looking at, but don’t be afraid to use various methodologies just in case. Lastly, when looking at undervalued stocks, the name of the game is speed, as they won’t stay that way for long!
Are you missing out on the next big investment opportunity? Undervalued stocks are hiding in plain sight, and Forbes’ team of top investment experts have identified 7 of the best stocks to buy for the second half of 2023. Some of these stocks are trading below their intrinsic value and have the potential to deliver outsized returns in the next 12 months. Get their names now.
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