InsideINVESTOR: Spotting Undervalued Stocks

By ShareInvestor

Where do I even begin?

You want to start your investment journey, but where do you start? Market conditions are always changing, and there are thousands of stocks out there. Which ones do you choose, and how?

Common wisdom says, “Buy low, sell high”. We’ve all heard of this concept, but when you are making a decision to buy a stock, how do you assess whether the current price is considered low or high?

You’re probably thinking of looking at the price chart for clues, but that’s only going to provide half the picture.

Step 1: Fundamental Analysis

Fundamental analysis is the first half of the battle, and it’s where you should start.

Let’s begin your investment journey with the golden rule of investing: only invest in what you understand.

A checklist to ask yourself:

  1. What is the company’s business?
  2. How does it generate revenue?
  3. Have profits been declining, growing, or maintained over the past 5 years?
  4. Does the company have a competitive advantage against competitors? Can it retain this advantage for the next 3 years?
  5. Does the company have room for growth?
  6. How does the company’s management make strategic decisions?
  7. Has there been a recent lawsuit or scandal? How serious is it?

If you can answer these questions and the fundamentals look positive, proceed to the next step.

The fundamentals need to be sound, as a company with good fundamental figures is unlikely to go bust anytime soon. That lowers your risk.

However, be careful that you don’t mistake bad information as useful ones to justify your investment. It’s easy to make that mistake, and in investing, mistakes cost money.

Step 2: Look for clues and opportunities

Now that we know how to get a clear picture of sound fundamentals, let’s explore how to find buying opportunities or identify stocks that could be potentially undervalued. Remember that the considerations below must be evaluated in totality; no point on its own should guide an investment opportunity.

  1. Earnings are growing
    • Growing earnings (retained profit, not increased revenue) imply that the company has become more financially efficient, which in turn implies lower risk and possible higher returns.
    • Caution: Past performance is not a guarantee or indication of future performance.
  2. Low Price-to-Earnings (aka. P/E) Ratio
    • Price-to-earnings ratio is a measure of how much money investors are willing to fork out to receive one dollar of the company’s earnings. This is derived by dividing the Market Price of the stock by the company’s Earnings Per Share (EPS) figure.
    • Lower P/E ratios may signal potential buying opportunities.
    • Caution:Caution: Consistently low P/E ratios over time may be indicative of a company’s poor performance.
  3. Low Price-to-Book (P/B) ratio
    • P/B ratio indicates the number of times that a company’s market price is greater than the book value of its equity.
    • If P/B ratio is less than 1, it indicates that investors believe that the firm is unable to utilize its assets profitably, and if it is greater than 1, it will mean that the company is overvalued and relatively more expensive than it used to be.
    • However, if other investment criteria (such as fundamentals) are sound, the stock may be undervalued, and this could be a buying opportunity.
  4. High dividend yield
    • Dividend yield tells you how a company’s dividend payout compares with its market price.
    • A high dividend yield means higher investment returns and may be a sign that the firm is undervalued.
    • Caution: What is the reason for paying high dividends? Does the company earn enough to sustainably pay generous dividends? Is the company unable to better use the profits retained, or is it the nature of its business/economic conditions? (e.g. US REITs get tax incentives for paying 90% of their profits as dividends.)
  5. Sudden dips in share price
    • A sudden decline in share price can occur for any number of reasons, such as panic selling on bad news.
    • However, if fundamentals are still intact despite recent bad news, the stock may then be undervalued.
    • Caution: Don’t catch the falling knife. Share prices can continue dipping for some time. You may want to wait for a sign of recovery (or at least see that the decline has stopped) before investing.

Step 3: Technical Analysis

Fundamental analysis alone won’t tell you everything you need to know about a stock. Technical analysis incorporates market activity and sentiment, which is equally important to your investment decision. One of the most basic element of technical analysis is a stock chart, which is the visual representation of a company’s share price movement over a certain period.

Line Chart

  • This type of chart connects the closing prices over a certain time frame and shows the overall view of price movements to project if the company is in an upward or downward trend.

Bar Chart

  • Bar chart shows the highest, lowest, opening and closing price of a company’s share on the very day.

Candlestick Chart

  • Candlestick charts is illustrated using a horizontal line to illustrate the opening and closing price, which is connected with a vertical box to form the ‘body’ of the candlestick. Traditionally, the colors green or red are filled in the body to indicate if the prices close higher or lower than the opening pricing respectively.

There are numerous technical analysis methods out there, but there isn’t a strategy that can fit all or most kinds of investment requirements, so it is recommended for you to do some reading to find ways that work for you in identifying good buying opportunities and avoid losing trades.

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