Here are 7 essential criteria to identify undervalued stocks

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When you buy a stock, you want to evaluate if its current price is higher or lower than what it’s worth over the long term.  All sorts of events which have nothing to do with a stock’s intrinsic value can affect its price, and frequently this means that stocks are undervalued.  For example, Steve Symington argues that CenturyLink is currently undervalued because investors haven’t yet accounted for the long-term impact of its imminent merger with Level 3 Communications, which, he predicts, “could be a fantastic driver of shareholder value.”

WHAT IS VALUE INVESTING?

Value investing identifies undervalued stocks.  The Motley Fool defines value investing in this way:

“Value investing consists of investing in stocks trading at prices below their intrinsic value. Value investors, therefore, are essentially buying stocks at a discount to what they believe they are worth, in hopes these investments will eventually rise to reflect their intrinsic value.”

Value investors understand the market often undervalues stocks based on news and events which have little if anything to do with the long-term fundamentals of those stocks.  They apply specific strategies to identify and invest in such stocks.

HOW TO EVALUATE STOCKS: THE GRAHAM MODEL

Royden Ward, a value investor for decades, developed a computerized value investment stock selection model in 1969 based on the investment strategy of Warren Buffett – and his mentor, Benjamin Graham. In Cabot Benjamin Graham Value Investor, he lays out 7 criteria for value stock selection based on Graham’s theories:

1. Quality rating

Ward recommends looking at stocks with a quality rating that is average or better.  Like Graham, he advises using Standard & Poor’s rating system to find out stocks with an S&P Earnings and Dividend Rating of B or better (on the S&P scale of D to A+).  To be safe, Ward says, it’s best to choose stocks with quality ratings of at least B+.

2. Debt to current asset ratio

In value investing, it’s important to select companies with a low debt load (this is especially important when lending is tight and the economy is relatively weak).  You should select companies with a total debt to current asset ratio of 1.10 or less.  There are a number of services which supply total debt to current asset ratios, including Standard & Poor’s and Value Line.

3. Current ratio

The current ratio provides a good indication of how much cash and current assets a company has—something that demonstrates they can weather unanticipated declines in the economy.  You should buy stocks from companies with a current ratio of 1.50 or higher.

4. Positive earnings per share growth

To avoid unnecessary risk, value investors look for companies with positive earnings per share growth.  Specifically, you should examine this metric over the past 5 years, and prioritize companies where earnings increase over that time period.  Above all, avoid companies which posted deficits in any of the last 5 years.

5. Price to earnings per share (P/E) ratio

You should select stocks with low P/E ratios, preferably 9.0 or less.  These are companies that are selling at bargain prices (in other words, they’re undervalued).  This criterion eliminates high growth companies, which, according to Ward, should be assessed using growth investing techniques.

6. Price to book value (P/BV)

P/E values are helpful, but they should be viewed contextually.  Specifically, you also need to consider the current price of a stock in relation to its book value, which gives you a strong indication of the underlying value of a company.   As a value investor, you want to invest in stocks which are selling below their book value.  The P/BV ratio is calculated by dividing the current price by the book value per share.

7.  Dividends

You should look at companies which are paying steady dividends.  Undervalued stocks eventually tick higher as other investors figure out they’re worth more than what their price suggests, but that process can take time.  If the company is paying dividends, you can afford to be patient as the stock moves from undervalued to overvalued.

CONCLUSION

The criteria which Ward uses provide a useful strategy to identify and invest in undervalued stocks—but it’s also important to understand the underlying conditions within a company which are the cause of its bargain price.  For example, a stock could be undervalued because the company is in an industry which is dying.

If a company is experiencing a problem which is the root cause of its undervaluation, you need to know if that problem is short or long-term, and whether the company’s management has a sound plan to address it.

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