Finding undervalued stocks isn’t as simple as chasing low P/E ratios or buying stocks just because they’ve dropped in price.
The real goal is to find strong, high-quality companies that the market has overlooked.
To do this, investors can use a combination of valuation metrics, growth indicators, and financial health measures to separate potential bargains from value traps.
This article will break down some of the most effective metrics for identifying undervalued stocks.
Valuation Metrics: The Foundation of Value Investing
The first step in finding undervalued stocks is to look at a stock’s key valuation metrics.
These numbers give investors a quick way to tell if a stock might be trading for less than it’s worth.
1. Price-to-Earnings (P/E) Ratio
- Best for: Profitable companies with stable earnings
- How it works: Measures how much investors are willing to pay for each dollar of earnings.
- What to look for: A low P/E ratio compared to industry peers may show that the business is undervalued. However, this could also show that the business is lower quality.
- Example: In 2022, Alphabet (GOOGL) dropped to a P/E of around 15, significantly lower than its historical average, despite strong revenue growth. The stock proceeded to double in a little over 2 years.
2. Price-to-Book (P/B) Ratio
- Best for: Asset-heavy industries (banks, real estate, industrials)
- How it works: Compares the stock price to the company’s book value (assets minus liabilities).
- What to look for: A P/B ratio below 1 suggests the stock may be trading below its net asset value. It’s important to check the company’s asset value, to make sure it deserves to trade at a higher P/B.
- Example: In 2009, Wells Fargo (WFC) traded below its book value despite having strong deposit growth and a solid banking franchise.
3. Enterprise Value to EBITDA (EV/EBITDA)
- Best for: Capital-intensive businesses (energy, telecom, industrials)
- How it works: Measures a company’s total value relative to its operating earnings.
- What to look for: A low EV/EBITDA ratio compared to industry averages may signal that the stock is undervalued.
4. EV/Revenue Ratio
- Best for: Growth companies with inconsistent earnings
- How it works: Compares a company’s total value (including debt) relative to its revenue.
- What to look for: A low EV/Revenue ratio relative to competitors or historical levels may indicate that the stock is undervalued.
- Example: In 2022, Shopify (SHOP) declined to an NTM EV/Revenue ratio below 5, despite continued strong revenue growth
Growth Metrics to Watch For
Growth metrics help determine whether a company is fundamentally strong and capable of increasing earnings.
A business that’s growing earnings or paying a nice dividend helps to give the stock a reason to rise in value.
1. Earnings Per Share (EPS) Growth
- Best for: Confirming earnings stability and expansion
- How it works: Measures profit per share over time, indicating whether the company is growing.
- What to look for: Consistent, positive EPS growth could lead to the business continuing to grow over the long-term strength, even if a stock is currently undervalued.
- Example: In 2023, Meta (META) saw EPS growth accelerate after cutting costs, leading to a stock price recovery.
2. Revenue Growth Rate
- Best for: Assessing whether the business is expanding
- How it works: Measures how fast a company’s revenue is increasing year over year.
- What to look for: Strong revenue growth shows that the business can continue to grow, which could lead to the stock’s price increasing.
- Example: Amazon (AMZN) in the early 2000s was losing money but had explosive revenue growth, making it undervalued based on future potential.
3. Return on Invested Capital (ROIC)
- Best for: Measuring capital efficiency
- How it works: ROIC evaluates how well a company generates returns relative to the capital it reinvests.
- What to look for: A high ROIC compared to industry peers suggests a company can sustain long-term growth. Over 20% returns on capital is usually very strong, but it can be best to compare to a company’s peers.
- Example: Apple (AAPL) has seen returns on capital above 20%, showing its ability to monetize past investments.
4. Dividend Yield & Payout Ratio
- Best for: Income investors looking for stable returns or investors looking to “get paid to wait” for a stock to reach its expected fair value.
- How it works: The dividend yield compares annual dividends to the stock price, while the payout ratio measures dividends as a percentage of earnings.
- What to look for: An excessively high dividend yield may signal risk, but a strong dividend yield with a payout ratio below 70% might signal that this is a high-quality stock.
- Example: In 2022, Verizon (VZ) had a dividend yield above 7%, making it attractive to income investors while maintaining solid cash flows.
Using growth metrics alongside valuation metrics can help investors find high-quality stocks that are undervalued.
The next step is to see what a company’s insiders and analysts think about the stock.
Find the best high-growth, high-quality stocks with TIKR >>>
Analyst Expectations & Insider Activity
Even if a stock looks undervalued, it’s smart to check what analysts and insiders think.
Analyst price targets can reveal Wall Street’s expectations for a stock, and insider buying shows if a company’s executives are confident in the stock.
TIKR makes it easy to track both.
Analyst Price Targets
ASML (ASML) currently has an average price target of $874 per share, which means analysts think the stock has nearly 20% upside.
Analyst price targets aren’t always right, but it’s a good idea to check them to double-check what you think the fair value of a stock is:
Insider Buying Activity
Insiders at Nike have been buying the stock, which is a good sign for the stock.
Insider selling isn’t always bad because we don’t always know why these people are selling the stock. Sometimes, insiders and company executives are just looking to diversify their portfolio or selling for personal reasons.
But when insiders are buying the stock, that’s a sign of confidence for the company because there’s only one reason they’re buying the stock. They think it’s going to go up!
Frequently Asked Questions (FAQs)
1. What are the best metrics to find undervalued stocks?
The best metrics to find undervalued stocks include valuation ratios like P/E, P/B, and EV/EBITDA, as well as growth indicators like EPS growth and revenue growth. Additionally, financial health metrics such as debt-to-equity ratio, free cash flow yield, and interest coverage ratio help confirm whether a stock is undervalued for the right reasons.
2. How do you tell if a stock is undervalued or a value trap?
A stock is undervalued if it has strong fundamentals but is temporarily mispriced. In contrast, a value trap is a stock that looks cheap but continues to decline due to poor growth, high debt, or a declining industry. To avoid value traps, investors should check earnings growth, competitive advantages, and financial stability before buying.
3. Which valuation metric is most reliable for value investing?
The most reliable valuation metric depends on the industry. The P/E ratio works well for profitable companies, while the P/B ratio is better for asset-heavy businesses like banks and real estate. EV/EBITDA is preferred for capital-intensive industries, and EV/Revenue works best for unprofitable businesses. A combination of metrics is often the best approach.
4. Why is EPS growth important when evaluating undervalued stocks?
EPS growth is important when evaluating undervalued stocks because it shows whether the company’s profitability is increasing over time. A stock may look cheap based on valuation ratios, but if its earnings are shrinking, the business might not recover. Consistent EPS growth signals financial strength, potential for future stock appreciation, and the ability to reinvest profits into expansion.
5. How do financial health metrics help avoid bad investments?
Financial health metrics help avoid bad investments by ensuring that an undervalued stock is not cheap due to fundamental weaknesses. By checking these metrics, investors can avoid companies that appear undervalued but are at risk of long-term decline.
TIKR Takeaway
Finding undervalued stocks is more than just looking for stocks that trade at a low P/E multiple.
Investors can find undervalued stocks by using the right mix of valuation, growth, and financial health metrics.
The TIKR Terminal offers industry-leading financial data on over 100,000 stocks, so if you’re looking to find the best stocks to buy for your portfolio, you’ll want to use TIKR!
TIKR offers institutional-quality research for investors who think of buying stocks as buying a piece of a business.
Disclaimer:
Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks. We create our content based on TIKR Terminal’s investment data and analysts’ estimates. We aim to provide informative and engaging analysis to help empower individuals to make their own investment decisions. Neither TIKR nor our authors hold any positions in the stocks mentioned in this article. Thank you for reading, and happy investing!
