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How to Find Undervalued Stocks for Beginners

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EquityChamp

EquityChamp
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How to Find Undervalued Stocks for Beginners
Investors often underperform the market because they do not buy stocks that are healthy and undervalued; instead, they often buy stocks that are overhyped and overpriced.
The reason for most investors sub-par performance is simple: Stocks covered by the media and closely followed by the masses are far less likely to be undervalued.
It is not just the average Joe investors that get caught up in the frenzy of chasing these ‘hot stocks’. When stocks soar, Wall Street analysts immediately tell us to Buy! When stocks drop, these experts then tell us to Sell (actually, they tell us to Hold because there’s an unwritten rule on Wall Street to not signal Sell except in the most extreme circumstances). Everyone seem to think they should buy stocks that are rising and sell stocks that are falling. Following this mentality, you’ll end up investing in the same stocks everyone is investing in and your performance will be no different than theirs—average at best.
Can you really blame them? Analyzing the thousands of publicly traded companies on the stock exchange is a daunting task. Is there an easy way to find the hidden market gems?
I’d argue there is, and I will guide you through my simple 3-step process of finding stocks of outstanding companies at bargain prices.
It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Warren Buffett, Chairman and CEO of Berkshire Hathaway Inc
Step 1: Generate Ideas

Goal: Identify 15-30 companies to analyse further

Finding the right stocks to analyse is a common issue that many investors struggle with, but it is easier than you might realize. Compared to a decade ago, investors today now have a wealth of information and powerful tools available to them to make informed decisions regarding their investment opportunities.

One valuable tool that can help you filter out the garbage and find the best value stocks is a stock screener. An online stock screener is my preferred method for generating stock ideas because it allows you to make independent, rational, and unbiased selection of value stocks that are not influenced by the emotions or opinions of others.
Value Tip
Remember, value investing is about looking for undervalued stocks of solid companies. A cheap stock is no good if the financial situation of the underlying company is bad.

Here is the basic criteria I always start of with:
1. Market Cap > Rs100 Million
Minimizes your risk to financially stable companies yet includes Small Cap stocks which are less followed by analysts and more likely to be mispriced. According to several studies, Small Cap Stocks have significantly outperformed Large Cap stocks over the past century.
2. Current Ratio > 1.50
Ensures that a company has more money flowing in (short-term assets) than what is flowing out (short-term liabilities). A current ratio of 1.0 means there are just as many assets coming in as there are current liabilities going out.
3. Return on Equity > 15%
Indicates high profitability. If a company has a high RoE 5-year average, it shows they are able to consistently reinvest money effectively and may potentially have a sustainable competitive advantage.
4. Debt-to-Equity ratio < 0.50
Implies that a company does depend heavily on outside capital to finance growth.[/column]
How to Find Undervalued Stocks for Beginners Aovi_google_stock_screener
Art of Value Investing Criteria on Google Finance Stock Screener

Optional Stock Screener criteria:

5. Dividend Yield > 1%
It’s always nice to receive a steady income for holding onto a stock until its value is realized. During a recession or bear market, it is not uncommon to see dividend yields of 15%! Adjust your screener requirements accordingly.
6. Price-Earnings ratio < 15*
P/E is tricky to filter with because the average P/E ratio can vary significantly between industries. As such, you can potentially exclude great investment opportunities by using a stringent P/E limit. However, the standard 15 maximum threshold does often works well for the majority of stocks. Just remember to be adaptable as you learn the average P/E ratio of certain industries. Similarly, I would avoid stocks with suspiciously low P/E ratios (less than 3) because it may be a bad business.
7. Price-to-Book Ratio < 1.50
In my opinion, this isn’t as viable as it once was…however it still works great as an additional filter to further narrow down your stock ideas. True to the art of value investing, using the P/B ratio you can filter out companies that may be overvalued and find potential undervalued stocks with a lower P/B ratio. Similar to the Price-Earnings ratio, I would avoid stocks with a P/B ratio less than 0.5 because they are likely to be companies without a solid business model.

Stock Screeners

Once you have determined the criteria fits your requirements, use any of the following free online stock screeners to develop a pool of about 30 stock ideas:
Google Finance
This is my go-to choice and personal favorite. Google’s free stock screener utilizes an intuitive interface and makes it simple to apply your criteria and filter out the best value stocks based on your requirements.
Yahoo Finance
An alternative to the Google Finance screener, Yahoo offers both a basic online screener and an advanced Java-based screener.
Value Explorer
A pre-defined screener that limits some flexibility; but one of my favorite tools to help generate value stock ideas based on fundamentals of Benjamin Graham and Joel Greenblatt. This website requires a membership, but it is free to sign-up.
OSV Pre-defined Screeners
An excellent resource with several pre-defined screeners based on various schools of ‘value investing’.

Stock Idea Alternatives

Stock screeners is simply a means of narrowing down and identifying worthwhile stocks to analyze. Alternatively, you can also subscribe to paid or free investment newsletters that can help generate investment opportunities for you. However, be mindful of what source you go with—there are many different investing styles and it may be completely different from your approach.
Remember to not blindly trust what others recommend and always do your own due diligence. This is especially true when dealing with commodities (oil, gold, etc.) or temporarily crises (BP Oil Spill, US Automotive Bailout, etc.).
Another consideration is to follow investing blogs and follow financial news sources. However, you must take great caution in doing so because many of these financial resources have a vested interest in hyping certain stocks, companies, and industries. Do not allow them to cloud your rational judgement without unbiased evidence.
Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important.
Warren Buffett, in Berkshire Hathaway’s 2013 annual shareholder letter
If you have other recommendations or creative solutions for generating stock ideas, please feel free to share your thoughts with us here at Art of Value Investing so we can all learn from your experiences!
Step 2: Assess the Business

Goal: Reduce your pool of stock ideas down to 5 (or less) outstanding companies

How to Find Undervalued Stocks for Beginners Aovi_undervalued_stockideas
Now that we’ve filtered out most of the bad investment opportunities, we can continue on to identify if any of these remaining 15 to 30 companies have the characteristics of an outstanding company with above-average market performance.
With one simple screening process, you’ve managed to filter out thousands of stocks down to a handful of prospective gems. Now it’s time to dig deeper to identify which ones, if any, are the most valuable and worth investing in. We will analyse these companies and look for the same characteristics of outstanding companies that Warren Buffett, the greatest value investor, uses in determining a winning business investment:
Buffett’s 1st Rule: Focus on a business that you understand.
Buffett has always avoided technology businesses. This is because he and his business partner, Charlie Munger, only stick to businesses that they understand. Sure, times has changed and there are several technology companies that may blow the market out of the water in the next few years. However, if you are not a technology expert, how would you find these stocks? Remember, when you are buying a stock, someone else is selling it because they see better opportunities elsewhere. Stick with solid companies with business models that you understand; you’ll have an advantage over many investors who don’t understand the business and it’ll be easier to make reasonable projections about their future performance.
Buffett’s 2nd Rule: Look for a sustainable competitive advantage
In any highly profitable business, competitors are quick to come in and get a piece of the pie for themselves. Unless a company possesses a a wide moat, increased competition will often reduce these high margins into lower profits. Look for companies with proprietary processes or technologies that are patented, trademarked, or not easily duplicated.
Buffett’s 3rd Rule: Search for honest, competent, and shareholder-friendly management
Peter Lynch summarized it best when he said, “Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.” The impact that leadership can have on a business is significant. Good management can be the key difference between generating steady profit growth and unreliable hit-or-miss earnings. Always try to look up the names of key executives of companies you find to learn more about them and their track record. Look for any warning signs by adding key words such as “scandal”, “fraud”, and similar words to your search. Apply this search strategy to the company as well. As a general rule of thumb, a company with high growth potential and consistently high returns on equity should be reinvesting a majority of its earnings back into the company. Otherwise, you are better off receiving a dividend and/or shares buybacks.
Buffett’s 4th Rule: Find favourable long-term prospects
Look for stock of businesses that you can hold onto forever. This may be counter-intuitive to several day traders; but the idea is simple. A stock is essentially owning part of the business itself. You should not think of it as a ‘stock decision’; but as a ‘business decision’ because every share is proportional to business earnings. Just as you wouldn’t buy a business to sell the next day, you should treat your investments the same way. Sure there are plenty of companies that have a good year now and then, but many of them lack a sustainable business. If you have any doubts about a company’s products in 10 years, that’s a warning sign to consider before investing.
Buffett’s 5th Rule: Aim for low debt levels
Warren Buffett has a strong dislike for debt and avoids investing in companies with too much debt—particularly long-term debt. Companies with heavy long-term debt are vulnerable to increases in interest rates which can significantly impact profits and make future cash flows less predictable. In the worst case, if the debt cannot be repaid, it can quickly send a company into bankruptcy. Therefore, to minimize your risk potential, focus on companies with a long-term debt-to-equity ratio below 0.50 and a current ratio above 2.
It’ll take some time and work, but by analysing each of the 15 to 30 companies from your screened pool with these rules, you will be able to identify the best possible investments with the highest prospect of outperforming the market.
Step 3: Find the Intrinsic Value

Goal: Determine if any of the opportunities you identified are undervalue

Now that you’ve determined the best companies available to you, it is time for the most exciting part: finding the value of these companies and determining if they are priced right to buy!
The right price is the one that provides you a wide margin of safety that will minimize your downside risk even if the company’s future performance not entirely as expected. You should only consider buying when the current stock price is 25% – 50% lower than the intrinsic value. Because the stock is already very cheap, you are able to negate most of the downside risk while simultaneously maximizing your upside return potential when the intrinsic value is realized.
Heads, I win; tails, I don’t lose much.
Mohnish Pabrai, The Dhandho InvestorHow to Find Undervalued Stocks for Beginners Ir?t=thinkintui-20&l=as2&o=1&a=047004389X
How to Find Undervalued Stocks for Beginners Aovi_undervalued_intrinsicvalue
There are several ways to calculate the intrinsic value of the company; however, some effective and easy methods includes:
1. Discounted Cash Flow (DCF)
The discounted cash flow method is one of the most popular and my favorite method for calculating the intrinsic value of a company. This powerful valuation formula determines the intrinsic value of a company by finding the sum of the future cash flow of a business and discounting it back to the present value.
2. Graham’s Formula
As originally published in The Intelligent InvestorHow to Find Undervalued Stocks for Beginners Ir?t=thinkintui-20&l=as2&o=1&a=0060555661 by Benjamin Graham, the father of value investing and mentor of Warren Buffett, developed a formula to determine the intrinsic value of a stock. The original formula as described by Graham was as follows: Intrinsic Value = EPS * (8.5 + 2g). In this case, g is defined as the reasonably expected 7 to 10 year growth rate 8.5 represented the effective base P/E for a stock with 0% growth.
3. Price-Earnings Multiple
A surprisingly simple, yet highly effective method for deriving intrinsic value from calculating the net present value (NPV) on the 5-year price target estimate of a company.
Any of these formulas can be used to estimate a company’s intrinsic value. However, remember—with any valuation model—the final number is not intended to be the true vale of a stock, but to provide an approximate range of the possible values. As such, it is important that you learn and utilize several valuation methods in order to have many intrinsic value estimates to average against the stock’s current market price prior to your investment decision.
Is the price of the stock you are analysing trading at way below your intrinsic value estimates? If so, congratulations! It is quite rare to find a company that meets the all of the outstanding characteristics that we looked for in Step 1 and Step 2 and also have it be trading at a significant discount compared to its intrinsic value.
At this point, it’s always good to rerun your analysis and review your data. If your research confirms that you have an wonderful company on your hands that is significantly undervalued, it’s time to reap the rewards of your labour and invest! If the price is too high (or margin of safety is too little), add these stocks to your watch list so you are able to jump on the opportunity when the price is right.
Final Words
I hope this was helpful in teaching you the process and fundamental Art of Value Investing. My inspiration for developing this detailed guide was because of the challenges I’ve faced when I was first starting out investing. As such, I have compiled years of valuable knowledge and experience into this resource as the valuable handbook that I wish I had when I started out as an investor!

Yahapalanaya

Yahapalanaya
Senior Vice President - Equity Analytics
Senior Vice President - Equity Analytics

Good one EC.

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