The stock market offers many ways to grow money. You may be wondering how to find undervalued stocks for your stock portfolio to help you achieve your goals.
Long-term investors research the fundamentals of companies to buy and hold shares in their portfolios.
Swing traders and options traders take advantage of the volatility of the market, and attempt to make profits from short-term price movements.
Day traders use intraday price changes to scalp quick, small profits.
Long-term investors ignore the short ups and downs in the market.
They build their portfolios with solid stocks that generate income from dividends, with stocks that have growth, and with undervalued stocks that have the potential for great rewards in the future.
Why Should Undervalued Stocks Be In Your Portfolio?
If a company is truly undervalued, it has the potential for explosive growth.
It may be undervalued because “the crowd” hasn’t yet discovered the true potential of the company.
Warren Buffet, the CEO of Berkshire Hathaway, became wealthy by finding and investing in undervalued stocks.
How Do You Find Out If A Stock Is Undervalued Or Overvalued?
A stock is considered to be “undervalued” when it is trading at a price that is lower than what the investor believes is a fair value.
In contrast, an “overvalued” stock is one where its current price is higher than an investor believes the company is worth.
To determine if a stock is overvalued, undervalued, or fairly priced, an investor must do his or her homework, looking into the company’s fundamentals, evaluating the industry or sector it is in (healthcare, oil and gas, technology, etc.) and comparing it to the price of other similar businesses.
Investors use various methods for determining a company’s fair stock price value, including fundamental analysis and technical analysis.
Technical analysis is the break down of a stock’s price behavior by looking for patterns, by drawing trendlines on stock charts, and evaluating data using various mathematical indicators.
Technical analysis is typically used by traders to form opinions of the near-term movement of a stock’s price. Technical analysis reveals the feeling of the crowed about a stock.
Consider it to be “the math of mass psychology,” as one author describes it.
Although most technical indicators are generally more useful for predicting short-term stock moves, trends can sometimes run for a long time.
While determining a trend can be subjective to a point, rely on objective indicators such as the Average Directional Movement Index (ADX) and Bollinger Bands®.
The Average Directional Movement Index
Drawing trendlines on a stock chart can give us a prediction as to the expected direction of a stock’s price movement, but traders also need to evaluate the strength or weakness of such movements.
The Average Directional Movement Index, referred to simply as the ADX, is a technical indicator used to measure the overall strength or weakness of a trend.
The ADX line itself is usually displayed as a black or blue line, and a numerical value between zero and 100 is assigned to it. The line is plotted beneath a stock’s price chart.
This line should be at a value of 25 or above to indicate that prices are trending. A rising ADX number, say from 15 to 20, means the current trend can be expected to continue (up, down or sideways).
When the ADX value turns down from higher values, the current price trend could be coming to an end.
The ADX is a “trend strength indicator,” measuring the strength of a trend and whether or not a stock is in a trending or non-trending period.
It can be confusing at first seeing the ADX line move upward, while the stock moves downward. But remember, the ADX line does not indicate direction.
It indicates strength. So if the ADX line is moving up and the stock price is moving down, this means that the downward trend of the stock price is strong. and the stock price is likely to continue to fall.
Investopedia.com defines Bollinger Bands® as “a technical analysis tool defined by a set of lines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of the security’s price.”
“Bollinger Bands® bracket the 20-day simple moving average (SMA) of a stock with an upper and lower band along with the daily movements of the stock’s price.
Because standard deviation is a measure of volatility, when the markets become more volatile. the bands widen; during less volatile periods, the bands contract.”
Bollinger Bands® are useful in identifying a stock’s trend, strength and “volatility”.
Volatility refers to how a stock’s price varies over time. A high volatility stock will have large price moves over a given period of time.
A low volatility stock will have small price moves over a given period of time. Bollinger Bands® are plotted directly on the stock chart, making them easy to see and interpret.
The upper and lower Bollinger Bands® give an objective way of determining support and resistance levels, as can trendlines. Drawing trendlines, however, tends to be somewhat subjective.
When a stock’s price approaches the upper band, it can be considered to be near overbought territory. Similarly, when a stock’s price approaches the lower band, it is considered to be near oversold territory.
Read Also: What Are The Most Common Types Of Charts For The Stock Market?
A stock’s price will travel between the upper and lower bands 95% of the time. Since these bands are based on price volatility, they don’t stay a constant distance away from the center line.
When volatility wanes, the bands become tighter together, because they are looking at what the price has done over the last 20 days.
In the book “The Master Swing Trader” by Alan S. Farley, the author explains how to interpret the bands:
“Price within the upper band signifies power, while price within the lower band signals weakness.”
Also, “Bands flatten in response to an awakening trend. If the angle of the lower band flattens in response to approaching price, expect price bars to pierce the band and reverse.
This will likely end a downward swing and start an upward one. But watch if price pulls back slowly while the band then opens. This will signal an impending breakdown.”
A stock’s price typically bounces off a band’s edge when it is hit, until enough strength builds to push the band out.
Bands often need to “open up” to create a path for price. Be aware that other support and resistance levels besides the Bollinger Band® boundaries can also affect price movement.
Using a candlestick chart, when a candlestick touches the lower band, it can be a buy signal, though other indicators are needed for confirmation.
When a candlestick touches the upper band, it can be a sell signal, though again, other indicators are needed for confirmation.
This is more reliable if the stock has low volatility. When price bounces off of the bottom band, it may be a buy signal, and when price bounces down off the top band, it may be a signal to sell.
This is because, as noted earlier, that a stock’s price tends to stay within the bands 95% of the time.
When price touches the top band, then drops, and again heads toward the top band but does not come as close, expect price to go lower.
Price to earnings ration (P/E ratio) is a metric that measures a company’s current stock price in relation to it’s earnings per share.
Generally, a P/E ratio below 15 is inexpensive, and above 18 is expensive. If you are looking for an undervalued stock, you’ll want a low P/E ratio.
Also, you’ll want to compare it to the P/E ratio of it’s major competing companies. Consider the company to be undervalued if competitors have higher P/E ratios.
“The debt-to-equity (D/E) ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders’ equity,” states Investopedia.
This number reveals how stable a company is financially, as well as if it can easily obtain more money to finance growth.
CorporateFinanceInstitute.com explains, “A higher debt-equity ratio indicates a ‘levered firm,’ which is quite preferable for a company that is stable with significant cash flow generation, but not preferable when a company is in decline.
Conversely, a lower ratio indicates a firm less levered and closer to being fully equity financed. The appropriate debt-to-equity ratio varies by industry.”
Fundamental analysis requires understanding and study of data that deal with a company’s assets and liabilities, which can be done, but is not easy for the average investor.
Consider Disruptive Technologies
Step back and think about companies that are making products that can change how people do things. Personal computers, for example, killed the typewriter business.
Cars were originally very expensive, making them only available to the wealthy. Henry Ford’s mass-produced Model T brought the price down so that the average person could afford one.
In 1948, two McDonald brothers had the concept to open a food stand that offered a limited menu, but that the food was ready before patrons even ordered.
This cut into the restaurant industry, once the company became nationwide. The Covid pandemic required people to work from home, and students to attend school virtually.
Companies like Zoom benefitted tremendously from this paradigm shift.
Look for companies where the founder has a vision and a passion. Such entrepreneurial drive along with execution skills will ensure the strong growth of a company.
Watch the news to get ideas for companies to investigate. Browsing the Internet, and even simply taking a walk through town may give you insight into businesses you’ll want to look into.
Think about businesses that you have dealt with and who gave you exceptional service.
Once you have a few stocks to evaluate further, you will need to read financial reports from these companies.
Compare their assets and liabilities, and how they are changing from quarter to quarter or year to year.
How to Find Undervalued Stocks on Yahoo Finance
Use stock screeners, such as yahoo finance and finviz.com for more ideas.
Yahoo has a predefined filter setting specifically for finding undervalued stocks:
Another free popular stock screening website is a finviz.com, which has an incredible number of filters to scan by.
Morningstar.com has a 14-day trial that will find stocks trading at a discount to Morningstar’s analysts’ estimates of their fair value.
Value Investing Isn’t For Everyone
Personally, because of my late age in life, value investing may not be the place for my money. You should have an investment horizon of five or more years when investing in undervalued stocks.
Time will be necessary before results will typically be seen. There is no guarantee, of course, that the company you select for your portfolio will be a winner.
Even if it is, it will take time, perhaps several years, before the price rises significantly once analysts and institutional investors realize the company’s potential.
You will need patience, another thing I am short on when it comes to the stock market. For these reasons, I prefer trading short-term options.
Those who have time on their side, however, should definitely have some undervalued stocks in their portfolio.
Value Mutual Funds
If you don’t have the time nor the desire to do the necessary investigation and study required to find undervalued stocks on your own, consider investing through a value fund.
Vanguard, Schwab, Fidelity, John Hancock and others offer value mutual funds. Compare their returns over the past few years to see which fund might be best for you.
Do you have any favorite undervalued stocks right now? Let us know in the comments below!