How to Pick Undervalued Stocks

Undervalued stocks can grow your rainy-day portfolio.

Undervalued stocks can grow your rainy-day portfolio.

Undervalued stocks garner much attention from investors because of their potential to outperform the market. Value stocks are out-of-favor stocks that belong to companies with the power to overcome setbacks. They are cheaper than other types of stocks. According to the "Wall Street Journal," the cheapest 10 percent of stocks have outperformed the most expensive 10 percent by more than 9 percentage points since 1968. Learning to find such stocks can boost your portfolio dramatically.

Look for a low price-to-earnings ratio, also known as the P/E. The P/E simply compares the price to the company's earnings over the last 12 months. A low P/E indicates that the stock has been overlooked by buyers because there has not been enough demand to drive the stock price higher. Determine whether the P/E is low by comparing it to the average P/E of the overall stock exchange on which the stock trades. For example, according to the "Wall Street Journal," the average P/E of the S&P 500 index was 16.47 on Nov. 23, 2012. If you find a stock with a lower P/E, keep it on your list of potential value stocks.

Identify stocks with low trading volume. This is the measure of the number of shares that exchange hands per day. To identify the volume, look at a chart of the stock. Across the bottom, you will find a bar chart that extends higher on heavy-volume days and appears short on low-volume days. Look at a chart that shows at least one year of trading and compare the current trading volume to the stock's previous volume. If the bars on the chart run much shorter than usual, the stock is experiencing low trading volume. This means traders are not showing much interest in it.

Choose companies with high net profit margins. You can find the profit margin for stocks from the company's annual or quarterly reports. Compare the profit margin for a company to its industry averages. Note that you want net profit, not gross profit. A good net profit figure indicates that the company keeps expenses low.

Find stocks with a low 12-month relative strength. You can select a relative-strength indicator on most stock charts. A low figure for this indicator shows you that the stock is out of favor, meaning you may be on your way to discovering a good stock that other investors have overlooked.

Search for a low debt-to-equity ratio. You can find an average debt-to-equity ratio for an entire stock exchange and an industry. For example, the American Association of Individual Investors (aaii.com) compared Starbucks to McDonald's recently and found that Starbucks routinely shows a lower debt-to-equity ratio than both McDonald's and the restaurant industry as a whole.

Tip

  • You can enter low P/E, low trading volume, high net-profit margin, low 12-month relative strength, low debt-to-equity ratio and high revenue growth into an online stock screener. It will select potential stocks based on your criteria.
 

About the Author

Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.

Photo Credits

  • Jupiterimages/Comstock/Getty Images