What’s the winning formula to find the best undervalued stocks to buy now that will yield a steady return for the next few decades?
The winning formula, in a nutshell, is that:
Conduct independent research to find such quality businesses that have robust fundamentals and are trading much lower below than their underlying values. Then your task is to stay invested in the long run.
But the bitter truth is finding what stocks are undervalued right now is an onerous task than it seems.
How can I find which stocks are trading much lower than their underlying values?
To analyze whether a stock is undervalued or overvalued, you need to run independent research about any stock’s fundamentals and check whether they are fundamentally intact or not.
To gauge the fundamentals, analyze the company’s Quantitative factors and Qualitative factors.
How to do Quantitative Analysis of a stock?
Quantitative analysis of stocks allows an investor to calculate the stock’s potential to deliver robust returns in the long run after analyzing the data that you can be found in the balance sheet or the income statement of the company in a short amount of time.
Simply put, Quantitative analysis of a stock helps an investor to access the price movements by examining the quantitative data that you will get in the income statement or the balance sheet.
Quantitative factors can be described in hard numbers that include,
- Debt to Equity Ratio,
- Profit Margin,
- Earnings per Share,
- Dividend Payout,
- Return on Equity,
- Return on Capital Employed,
- Price to Sales Ratio,
- Price to Earnings Ratio,
- PEG Ratio,
- Price to Book Ratio,
Parameter #1. Debt to Equity Ratio
The Debt to Equity Ratio reveals if the company delivers a two-digit growth by pumping the external capital or with its own funds available.
The debt to Equity is calculated once you divide the total debt obligation a company has with its total shareholders’ equity.
By analyzing the debt to equity ratio you can calculate if the growth delivered by the company by pumping external capital exceeds the interest payable on the debt obligation or not. In the scenario of interest payable is in line with the growth delivered, the chances are higher that the share price will plummet once the business experiences a downturn.
The debt to equity ratio differs across various sectors. Take the example of the Utilities, Banking, and financial sectors. These sectors’ debt to equity ratio is relatively higher when compared to the Technology sector. As a good rule of thumb invest in those companies that are either debt-free or have marginal debt.
Parameter #2. Profit Margin
Profit margin describes to what extend the company generates a profit by running a business operation. Simply put, profit margin figures out how much paisa profit the company has made for each rupee of sale. For example, if the company has generated a 25% profit margin during the last fiscal year, then it can be assumed that the company has made a net profit of 25 for 100 of sales generated.
Like the debt to equity ratio, profit margin varies from one sector to another. As a good rule of thumb invest in those companies that have not only delivered a double-digit profit margin but also exceeded the peer average.
Parameter #3. Earnings per Share
To find the company’s profitability, several analysts often take into account of Earnings per Share. The earnings per share can be calculated by dividing the net profit a firm makes in a financial year with its total shares outstanding.
When a company’s EPS is higher, then the chances are higher that the investor will place a higher price for a stock once they find that the company has delivered a robust EPS relative to its per-share price.
A higher EPS doesn’t necessarily signal that the company will elevate the dividend payouts to the shareholders. It’s the board of directors’ call whether the company will declare an increased dividend or retain the profit to reinvest in the business.
Parameter #4. Dividend payout
By analyzing the dividend payout you can assume what dollar you can expect when you own stock in a financial year.
No matter how big a corporation is, take a close look at whether the company has delivered a two-digit profit growth and whether the company has a track record of paying dividends at regular intervals to its shareholders.
Parameter #5. Return on Equity
Return on equity helps an investor to measure the performance of the company in respect of managing its finances by taking into account of net income of a firm in a financial year and the total shareholders’ equity.
ROE can be calculated by dividing the net income generated by the company in a fiscal year with the total shareholders’ equity.
By analyzing the Return on Equity you can get detailed insights about the financial performance of the company to generate profit by running a business operation by utilizing the total shareholders’ capital.
As a good rule of thumb, invest in those companies that have delivered at least 15% ROE over the last 5 years.
Parameter #6. Return on Capital Employed
When it’s time to analyze the management’s efficiency it is established as to how the company utilizes the shareholders’ capital, the assets of the company to generate more profit etc. You will find Return on Capital Employed a handy financial ratio to analyze the above-mentioned factors.
In other words, RoCE helps an investor to gauge how well a company generates profit from the available capital. RoCE takes into account of assets, liabilities, debts, and EBITA.
RoCE is quite helpful to find the best companies that are operating in the sectors with significant debt. RoCE points out not only the management’s efficiency to manage the finances with a significant debt but also what percentage of profit is spent to pay back the debt obligation.
The higher the RoCE is, the higher profitable the firm is. Start investing in a stock that has ROCE either stable or is steadily rising year on year. And stay clear from investing in those companies with a deteriorating RoCE.
Parameter #7. Price to Sales Ratio
Typically the Price to sales ratio reveals what the investors are willing to pay when a company has $1 in sales.
The Price to Sales Ratio can be calculated by dividing the current market price per share with its sales per share in a financial year.
When you compare the companies that are operating in the same sector or industry, a stock with a lower P/S ratio can be treated as undervalued and a higher P/S ratio signals that the stock may be overvalued. The lower the P/S ratio is the better the investment opportunity is.
Parameter #8. Price to Earnings Ratio
When you perform a comparison between two companies that are operating in the same sector or industry, then the Price to Earnings Ratio is a gamechanger to find which stock is undervalued and which one is overvalued.
The Price to Earnings Ratio can be calculated once the current market value of a share is divided with the per-share earnings in a financial year.
But do remember that each sector has a different P/E ratio. A high P/E ratio doesn’t necessarily mean that the stock is overvalued. A high P/E can indicate that the investors are optimistic enough that the company will deliver robust growth in the long run.
Parameter #9. PEG Ratio
The Price-to-earnings ratio is quite a helpful matrix to gauge the valuation of a stock in comparison to its peer companies. It gives a snapshot of what the investors are paying for a company’s future earnings. But since the P/E ratio doesn’t count the future earnings growth, legion analysts take account of the Price-to-earnings/growth ratio since PEG Ratio takes account of not only the price-to-earnings ratio but also the expected growth rate to assess the valuation.
The PEG ratio reveals whether the stock is undervalued or overvalued when you divide the P/E ratio by its projected growth rate over a period of 5 years.
Let’s make it clear with the following example.
Suppose there are two companies namely ABC and XYZ operating in the same industry or sector. The Price to Earnings ratio of ABC and XYZ are 8 and 10. If you solely depend on the P/E ratio to find whether the stock is undervalued or overvalued then you will find the ABC as the most lucrative option.
But if you have taken into account the projected 5-year earnings growth rate of both the companies, the picture will alter since the projected growth rate of ABC and XYZ are 10% and 15% respectively.
Hence the PEG ratio of ABC and XYZ are 0.80 and 0.66 respectively. That means XYZ is the best option. It is trading at a discounted valuation.
After analyzing the PEG Ratio it can be concluded that the lower the PEG ratio is, the more lucrative the investment option is.
Parameter #10. Price to Book Ratio
By employing the price to book ratio, you can gauge if the company’s market capitalization is in line with its book value or not.
The Price to Book ratio is calculated by dividing the market price of a share with its book value per share.
Needless to say, you will get the market price when you type the company in the search engine. On the contrary, Book value reveals what you will get after the company liquidates all of its assets and pays all the debts in the scenario if the company goes bankrupt.
A company with a P/B Ratio of less than 1, indicates that the stock is undervalued. As a good rule of thumb invest in those companies with the P/B ratio varying between 1 & 3.
Parameter #11. Beta
To compare a stock’s volatility with the overall market, beta is quite a useful metric. Beta measures how much volatile a stock is in comparison to the overall market. For example, if the stock’s volatility is 1.30 then it can be assumed that the stock is 20% more volatile in comparison to the overall market. High beta stocks are more volatile but offer higher return potential. On the contrary, the low-beta stocks tend to be less volatile and offer lower returns.
How to do Qualitative Analysis of a stock?
Qualitative Analysis of stocks shed light on soft matrices of the company that require onerous efforts including.
- What is the business model of the company?
- Is the management of the company delivering robust performance by utilizing the shareholders’ capital?
- Does the company have a sustainable competitive advantage in any sector or industry?
Simply put, Qualitative analysis of stocks will help you to gauge how the company is running the business and make a profit and thereby rewarding the shareholders by declaring the dividends regularly.
While performing the qualitative analysis of stocks, here are the 4 factors that require close attention.
- Business model
- Competitive Advantage
- Customer Satisfaction
Parameter #1. Business Model
Business Model refers to the strategy or plans the company employs to make a profit by running a business operation. No matter what is the target audience or the business is a new venture or established one, a business model is super important.
While analyzing the business model of a company, do consider who are the end-users and if the product or services the company is offering right now will still relevant even after the next few decades. Apart from that do check whether the company improves its profit margin by utilizing the advanced technologies or by upgrading its product or services to tackle the peer competition.
Parameter #2. Management
No matter what is the net profit or the current share price is, when you want to pick a company that will yield better returns in the long run, you must focus on the management team. By analyzing the efficiency and the performance of the management team you can gauge the future potential in respect of profitability and returns.
When you are analyzing the management of the company, do analyze a company on the basis of the following parameters.
- Who is sitting on the top positions of the management team i.e. CEO, CFO, COO, etc?
- What is the performance in the recent past and past achievements?
- Is the management flexible enough with the employees?
- What strategies does the management apply to tackle the peer competition and enhance the earnings potential?
- Does the management recruit the talents and the cutting-edge technologies employed to cut the costs and enhance the earnings?
There’s no magic rule to evaluate the management of the company. But after you get satisfactory answers to the above-mentioned questions, you will get a clear picture of the future potential of the company.
Parameter #3. Competitive Advantage
A competitive advantage allows a company to generate more profits or a superior profit margin when compared to its competitors. For example, if you want to open a bank account and HDFC Bank comes to your mind as the first option, then it can be assumed that HDFC Bank enjoys a competitive advantage over its peer competitors. The chances are higher that the HDFC Bank enhances its profit margin as it enjoys a sustainable competitive moat over its peer competitors.
Parameter #4. Customer Satisfaction
Even today, customer satisfaction is one of the crucial factors. Take the example of HDFC Bank. The bank provides various facilities that enable users to check the balance right from their smartphone via missed call/SMS, or send money around the clock with a few clicks at the comfort of home, etc. All the facilities enhance customer satisfaction and help to retain the customer even when the other banks offer 0.50% higher interest rates on FDs.
- Read also: How to do Fundamental Analysis of a Stock
7 Best Undervalued Stocks to Buy Now
When you are hunting high and low for the best undervalued stocks to buy today and are ready to perform independent research, the sole factor that will lead to a favorable outcome is that: What’s your definition of undervalued stocks?
Let’s make it clear with an example.
A bulk of investors treat any stock as an undervalued one that is trading at 7 times the sales generated in a financial year.
On the flip side, a lion’s share of investors out there who are willing to pay 25 times of sales generated by a company a financial year.
Take the example of Tesla. Back in 2017, the investors were willing to pay 8 times of sales generated by the company in a financial year. Today the company’s share is trading at a whopping 20x of its sales. But still, a lion’s share of the investors are willing to own the shares at a higher valuation as they are optimistic enough that the company will deliver robust earnings growth in the long run.
Let’s take a glance at the 7 best undervalued companies to invest in that will yield the best returns in the long run.
Jefferies Financial Group Inc.
Started its journey in 1968, Jefferies Financial Group offers investment banking, capital markets, asset management, and direct investing services.
For the financial year 2020-21, the company’s revenues rose by 32.89% to $6.9 billion. Despite the revenue growth, still, the company is trading at an attractive valuation of 7.38 and offers a 2.46% dividend to its shareholders.
Here is the snapshot of the Jefferies Financial Group,
- Market Capitalization – $8.14 Billion
- Earnings Per Share – $4.47
- P/E Ratio – 7.38
- Forward P/E – 7.57
- Current Yield – 2.46%
- Beta – 1.48.
Gray Television Inc.
This is a television broadcasting company that operates 145 stations across the US that reach 24% American households.
For the financial year 2020-21, the company’s revenues witnessed a double-digit rise of 12.21% to $2.38 billion. Despite the revenue growth, the company is trading at an attractive valuation of 5.38 and offers a 1.58% dividend to its shareholders.
Here is the snapshot of the Gray Television,
- Market Capitalization – $1.91 Billion
- Earnings Per Share – $3.74
- P/E Ratio – 5.38
- Forward P/E – 12.94
- Current Yield – 1.58%
- Beta – 2.05.
This company offers insurance products and services to millions of people under one roof across the US and Europe. The company’s insurance portfolio includes disability insurance, life insurance, accidental insurance, and much more that will help the insurers to protect their families on the occasion of unavoidable circumstances.
Here is the snapshot of the Unum Group,
- Market Capitalization – $5.87 Billion
- Earnings Per Share – $3.88
- P/E Ratio – 7.42
- Forward P/E – 5.97
- Current Yield – 3.96%
- Beta – 1.78.
Morgan Stanley needs no introduction. The company offers wealth management, investment banking to manage the wealth of individuals, businesses, institutions the best plausible way across 42 countries.
Coming to the numbers, Morgan Stanely is constantly improving its ‘Funds from Operations’ for the past 5 years, and this year is no exception too. Even if the company witnesses a 3.28% deep in revenue, the company offers a healthy dividend yield of 1.73%.
Here is the snapshot of Morgan Stanley,
- Market Capitalization – $153.83 Billion
- Earnings Per Share – $7.62
- P/E Ratio – 10.76
- Forward P/E – 11.65
- Current Yield – 1.73%
- Beta – 1.57.
This fortune 500 company offers insurance products primarily to individuals across the United States. Its product bag includes life insurance, accidental insurance, medical insurance, dental insurance, disability insurance, etc. Needless to say, back in 2020, Cigna Corp. ranked 13 in the Fortune 500 list in the segment of largest United States corporations in respect of total revenue.
Here is the snapshot of the Cigna Corp,
- Market Capitalization – $86.99 Billion
- Earnings Per Share – $23.11
- P/E Ratio – 10.84
- Forward P/E – 12.29
- Current Yield – 1.59%
- Beta – 0.91.
Verizon Communications Inc.
Verizon operates in the Public Utilities sector that is engaged in offering wireless technology, Fiber Optic Service, Managed security solutions to individuals, companies, and government agencies.
The company’s goal is to not only provide 10 million youths with digital skills training by 2030 for the jobs but also become a carbon-neutral company by 2035.
Here is the snapshot of Verizon Communications Inc,
- Market Capitalization – $233 Billion
- Earnings Per Share – $4.56
- P/E Ratio – 12.35
- Forward P/E – 11.11
- Current Yield – 4.41%
- Beta – 1.
Methode Electronics Inc.
Located in Chicago, Methode Electronics is an American company engaged in designing and manufacturing components for aerospace, electronics, automotive, and other industries. The company has set up manufacturing facilities across America, Europe, and Asia.
Here is the snapshot of the Methode Electronics,
- Market Capitalization – $1.75 Billion
- Earnings Per Share – $3.17
- P/E Ratio – 14.38
- Forward P/E – 15.73
- Current Yield – 0.99%
- Beta – 1.27.
Since the number of companies listed in the New York Stock exchange is a whopping 2400, it’s a tuff call to pick the best stocks that are trading much lower than their underlying values. To find the undervalued stocks you should perform deep-down independent research and analyze a stock based on various parameters that are mentioned above. Additionally, after you have found the undervalued stocks stick to them with a long-term horizon since the stock market is a voting machine in the short run, but a weighing machine in the long run.
- Read also: 7 Best Stocks to Buy Right Now Under $20
Hope, this article will help you how to buy undervalued stocks that will yield the best returns in the long run. Have I missed any most undervalued stocks? Make a comment so that I can add it to this list.