Value Investing 101: How to Identify Undervalued Stocks?

When you are looking to invest in equities there are multiple strategies you can follow. Investors who don’t have any knowledge of the stock market can purchase ETFs or exchange-traded funds. ETF investing is the best option for the passive investor as it provides them with diversification lowering overall risks considerably.

Alternatively, for the active investor, there are a variety of options that include value and growth investing. Value investing is a strategy where the investor identifies stocks that are trading at a discount compared to their intrinsic value. Value investors believe the market exaggerates good or bad news which means price fluctuations are not in line with the stock’s fundamentals.

For example, the energy sector was decimated last year due to lower-than-expected demand and economic lockdowns. While stocks of oil-producing companies expectedly declined significantly, the sell-off in midstream companies such as Enbridge and Pembina Pipeline were exaggerated.

That sell-off offered investors an opportunity to buy quality stocks at a massive discount. Since mid-March 2020, shares of Enbridge are up over 40% while shares of Pembina Pipeline have more than doubled in market value.

Noted stock market investors including Warren Buffett and Benjamin Graham have been strong advocates of value investing. These stalwarts believe undervalued stocks have the potential to beat the broader markets consistently over the long term.

How to pick value stocks?

The higher the difference between the intrinsic value and share prices, the higher is the margin of safety. While the stock prices can take another dip from current levels especially if markets turn ugly, its decline will be limited compared to those trading at a premium.

Value stocks are ideal for defensive investors or for those with a lower risk appetite as it limits your losses and will derive outsized gains once shares are fairly priced.

It’s quite difficult to find undervalued stocks and requires in-depth research. There are many stocks that grossly underperform the equity markets each year but only a handful of them have the potential to stage a strong comeback.

While a value stock will trade at a cheap multiple there are other characteristics that define them. It’s advisable to look for companies that have a leadership position in the markets where they operate. These companies should have booked consistent profits and have stable cash flows over time. Ideally, value stocks should also pay investors a dividend but this isn’t a necessary requirement.

Important ratios that will help you pick value stocks

There are a few financial ratios that will help you identify and pick value stocks consistently.

Price to earnings

One of the most popular valuation ratios is the price to earnings (or PE) multiple. Here you divide the price of the stock with the company’s earnings. So, if the stock price of a company is $100 and it earned $5/share in 2020, its trailing PE multiple is 20x. This ratio basically shows us the dollar amount an investor invests to receive one dollar of earnings.

You should not view this ratio in isolation and the PE multiple should be compared with peers. If five companies are growing earnings at the same rate, the stock with the lowest PE ratio can be considered to be undervalued. Investors should also note that companies reporting a net loss will not have a PE multiple.

PEG ratio

An extension of the PE ratio, the PEG multiple, or the price/earnings to growth divides a stock’s PE ratio with its earnings growth over a specific period. In case this ratio is below 1, the stock can be considered undervalued.

For example, if a stock is trading at a price of $100 and is forecast to earn $10 per share its PE ratio is 10x. Now, if the company is able to grow its earnings at more than 10% each year, its PEG ratio will be lower than 1 making the stock attractive to value investors. You can find the 5-year PEG ratio of most publicly traded Canadian companies on Yahoo Finance.

For example, one of the most undervalued stocks on the TSX last year was Auto Canada. It was trading at $6.83 per share in May 2020 and has risen to $44 today.

It means the stock is trading at a forward price to earnings multiple of 15.8x given that analysts expect Auto Canada to report earnings of $2.84 in 2021. In the next five years, analysts expect 

Auto Canada to increase earnings at an annual rate of 24.9% which is higher than its PE ratio. 

Bay Street also has a 12-month average target price of $54 for Auto Canada stock which is 23% above its current trading price.

Price-to-book ratio

This ratio is used to compare a company’s market cap with its book value. The price to book ratio is calculated by dividing the price per share of a company by its book value per share. A company’s book value is the difference between a company’s assets and liabilities.

A price-to-book ratio of below 1x suggests a stock might be trading at a discount. Similar to other ratios, you need to compare a company’s price-to-book value with its peers to analyze if the stock is reasonably valued or not.

Dividend payout ratio

A company can distribute its profits to shareholders as dividends or retain it to pay back debt as well as to invest in capital expenditure. A company that pays a dividend should have a low payout ratio to keep these payments sustainable as well as increase them over the long term.

A company with a high payout ratio might be vulnerable to an economic downturn that impacts its bottom-line, following which it will have to reduce or roll back these payments.

A company with an attractive dividend yield and a low payout ratio should be on the radar of most investors as it has the potential to increase dividends in line with earnings expansion. 

Dividend stocks are underrated and can create massive wealth for investors. For example, if a stock has a forward yield of 4% and gains 10% in a particular year, its total returns will be 14%.

The bottom-line

These are just a few ratios for investors to consider when they aim to identify value stocks. There are several other multiples such as the current ratio, price/enee cash flow ratio, and debt to equity ratio that you can look at before making an investment decision.

Investors should also avoid the value trap which means a stock might look cheap but isn’t worth the risk. These might include companies part of cyclical industries or stocks that have lost significant market share to competitors.

Similar to most other forms of investing, value investors should be patient, allowing them to grow long-term wealth and benefit from the power of compounding.