9 essential tips for finding undervalued stocks

Imagine scooping up stocks before they skyrocket — like uncovering diamonds amongst coal. Undervalued gems are out there, waiting to be discovered by traders like you.

Undervalued shares present an attractive trading opportunity for traders who are seeking to buy stocks at a ‘discount,’ anticipating that their prices will eventually rise to align with their inherent worth.

What are undervalued stocks?

Undervalued stocks are stocks that are trading at a price lower than their intrinsic value. This can happen due to a combination of factors:

1. ‍Negative market sentiments: Sometimes, the overall mood of the market can turn sour due to economic uncertainty, world events, or a general downturn in the market. This can lead traders to hastily sell their shares.
2. ‍Disappointing earnings: If a company's earnings or future outlook isn't as good as expected, traders might lose confidence.
3. ‍Industry challenges: Certain industries face unique challenges, like new technologies or changes in regulations. This can negatively affect all stocks in that sector.
4. ‍Overreaction to news: Both good and bad news can lead to extreme reactions. This can temporarily push a stock's price away from its true value.
5. ‍Misunderstood fundamentals: Sometimes, a company's financial health is misinterpreted, causing traders to value it incorrectly.
6. ‍Limited information: Without enough information or transparency, traders might not see the true picture, leading to misjudgment.
7. ‍Short-term concerns: Matters like legal disputes or changes in management can temporarily unsettle traders until these issues are resolved.
8. ‍Trader behaviour: Various biases, panic selling, or following trends without proper analysis can lead to irrational decisions among traders.
9. ‍Hidden gems: Some companies, especially lesser well-known ones with solid fundamentals, might not get the attention they deserve in the market.

How to find undervalued stocks

The nine key financial indicators outlined below can help you find undervalued stocks in the market, as they unveil a company's potential to grow and succeed.

1. The Price-to-Earnings Ratio (P/E) compares the company’s stock price to its earnings per share (EPS). Think of it as a way to see how the market values the company’s ability to make money. A lower P/E ratio, especially when compared to other companies in the same industry or to the company’s own past numbers, could be a hint that the stock is undervalued.

2. The earnings yield is the inverse of P/E. Instead of comparing the stock price to earnings, it shows the earnings you get for each dollar you invest in the stock. A higher earnings yield suggests a stock might be undervalued as traders could be getting a relatively higher return for their capital.

3. The Price-Earnings to Growth Ratio (PEG) considers a company’s P/E ratio in relation to its earnings growth rate. A PEG ratio below 1 might indicate that the stock is undervalued relative to its earnings growth potential, suggesting that the market hasn’t fully recognised its future prospects.

4. The Debt-Equity Ratio (D/E) assesses a company’s financial leverage by comparing its total debt to shareholders’ equity. A lower D/E ratio implies lower financial risk, indicating that the company relies less on borrowed funds. A favourable D/E ratio could signal stability and the potential for long-term growth.

5. The current ratio assesses a company’s short-term liquidity. To do so, it compares what a company owns (its current assets) to what it owes (its current liabilities). An undervalued stock with a high current ratio shows that the company is well-equipped to pay off its short-term debts, which adds to its overall stability.

6. The Price-to-Book Ratio (P/B) compares a company’s stock price to its book value per share. The book value represents the net value of a company’s assets after deducting its liabilities. A P/B ratio below 1 may mean the stock is priced under its book value.

7. Return on Equity (ROE) measures a company’s efficiency in generating profits from shareholders’ equity. A higher ROE often indicates effective management and the ability to generate strong returns. If a stock has a high ROE but is still undervalued, it might mean the market hasn’t fully recognised the company’s earnings potential.

8. The dividend yield calculates the annual dividend income relative to the stock’s price. If a company manages to pay a steady dividend even when its share price is low, it’s a good sign that the company’s financial foundations are strong. But here’s a catch: if the company is using a lot of its earnings just to pay these dividends, it might not have enough cash left to grow its business or pay off debts.

9. Financial statements like an income sheet, balance statements, and earnings reports can give you a better understanding of the company’s financial strength and the viability of the business model. It’s important to look at future predictions, too. For example, if a company is expected to earn more in the future (estimated revenue growth) but the market hasn’t caught on yet, the stock could be undervalued, making it an attractive opportunity.

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How to trade undervalued stocks

Here are some tips for developing an effective approach to trading undervalued stocks.

• Evaluate the fundamentals: Distinguishing between undervalued stocks and those with weak fundamentals is vital to avoid falling into a "value trap," where stock prices remain low or even decrease. Traders can utilise the fundamental analysis techniques outlined above to accurately identify genuine undervalued stocks.
• Compare the competitors: Assessing a stock's fundamentals relative to its competitors can also provide valuable context. If a stock appears undervalued compared to its industry peers using the above metrics, it might indicate untapped potential.
• Make a trading plan: Use technical analysis to identify key support and resistance levels to help time your entries and exits. Look at moving averages, past trading ranges, and volume patterns to pinpoint ideal buying points when the stock is trading below its intrinsic value. You can use stop-losses to contain downside risk on any trades. Be sure to track your trades to assess what worked and what didn’t. Make adjustments to improve over time. One thing to bear in mind is that you may need to allow time for undervaluation to be corrected.

Blindly chasing cheap stocks can lead to losses. Before trading undervalued stocks, traders should have a comprehensive understanding of the underlying fundamentals complemented by proper research to make informed and strategic investment choices.

Put these tips into practice and identify undervalued stocks in Deriv’s portfolio of stock offerings. Open a demo trading account, which comes with virtual funds so you can practise navigating the stock market risk-free before trading with real money.