How to Spot an Undervalued Stock (2024)

Investing in undervalued shares could give your portfolio a boost if they eventually see significant price appreciation. The concept of value investing, developed by Benjamin Graham and popularized by Warren Buffett, essentially means investing in shares that are undervalued by the market. When a stock’s share price is well below its intrinsic value, that can be a bargain buy for investors. The payoff comes when that stock’s price begins to rise as the market catches on to its true worth. Investors then have an opportunity to sell, ideally for a sizable profit. This is the essential goal of investing: Buy low, sell high. The question is, how do you find undervalued shares to invest in?

A financial advisor can help you create a financial plan for your investment needs and goals.

How to Identify an Undervalued Stock

Finding undervalued shares to invest in requires some skill and know-how when it comes to how the market works. It also requires a discerning eye, since sometimes shares can appear to be undervalued when they actually aren’t. In that scenario, you might purchase a stock on the assumption that its price will increase over time, but it doesn’t. Instead, the price flatlines or worse, decreases, meaning you realize a loss rather than a gain on your investment. This is known as the value trap.

That’s what you want to avoid with a value investing approach. With that in mind, here are four ways to accurately spot undervalued shares.

1. Check the Ratios

Several ratios can be useful in assessing a stock’s value. Here are some of the most important:

2. Consider Cash Flow and Dividend Yield

Some companies pay investors a dividend, which represents a share of profits. The dividend yield and current cash flow can also be significant when trying to find undervalued shares to invest in.

In terms of dividend yield, it’s important not to be distracted by the number alone. A strong dividend yield suggests that a company is paying out a decent amount of profits right now, but you have to dig deeper. Specifically, you should be looking at a company’s cash flow, debts and dividend payout history to determine if the current dividend yield is sustainable.

If a company is paying the bulk of its profits out in dividends, for example, that may leave it with less cash flow to pay off debts or invest in growth for the long-term. When it comes to finding stocks that are undervalued, the key thing to look for with dividend yield and cash flow is consistency. If a company is continually paying out a steady dividend, despite a lower share price, that’s a sign that its underlying financials are strong.

3. Compare Competitor Pricing

Another way to evaluate whether a share is undervalued is to look at similar companies in the same industry. Here, you want to make apples-to-apples comparisons between the company you think is undervalued and other companies that sell at a higher price point.

Specifically, consider what’s driving the company’s share price to be lower than the competitionand how the price is trending. This is where looking at things like the moving average can be helpful. The moving average is a way to track price movements over time, accounting for both short-term and long-term pricing changes.

When looking at pricing trends, keep the drops in perspective and look at how the stock is trading relative to competitors. Also, it’s worth considering whether a competitor company is accurately valued. It could be that a competitor is overvalued, making the company you’re interested in appear to be worth less than it actually is.

4. Look at the Financials

When trying to find undervalued shares, it helps to have as complete a picture of the company’s financials as possible, not just a picture of metrics like the price-to-earnings ratio. That means reviewing the fundamentals concerning things like the income sheet, balance statement and quarterly earnings reports.

Looking at these things can help you get a better sense of how strong the company’s financial position is and how sustainable the business model is. A company that’s seeing steady positive earnings over a multi-year period with minimal debt, for example, could be a good candidate as an undervalued stock if those indicators aren’t reflected by an increasing share price. In other words, the shares could prove to be a dark horse whose potential isn’t being realized by investors.

Something else to consider is how strong a company’s financial position is, relative to its competitors. Specifically, you’d want to look for companies that may be undervalued but have opportunities to grow if a market downturn happens. These are the companies that have strong cash flow, minimal debt and are positioned to see steady or increased demand for their services or products in changing market environments.

Bottom Line

Picking undervalued shares takes some effort. The better you understand the basics of how to identify stocks that may be undervalued, the easier it may be to use a value investing strategy to boost your portfolio’s return profile. The key is remembering that there’s no definitive set of rules for identifying the right shares to invest in and that like anything else, there’s still a certain amount of risk involved.

Tips for Investing

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