How do I find undervalued stocks in the market
Since the stock market is so hot nowadays, where even uncle aunties who never traded in the stock markets are now talking about making money in gloves and healthcare, I want to cover a topic on business valuation.
This is an extension of one of my 8 investment principles in stocks (No. 5 – Valuation at low end compared to peers).
As a business valuer since I started my career, I find that business valuation is more art than science and it can get very complicated.
It typically takes 2 weeks to 1 month to complete a business valuation (with a lot of Excel workings and mumbo jumbos). The longest business valuation I’ve done was 2 months+ but that’s a very super complicated business.
With that said, we all don’t have the time (and don’t want) to be doing a full scale valuation for our stock investments. Yet, we can’t run away from valuation when we talk about value investing – i.e. finding undervalued stocks.
When does valuation come in?
Essentially I only check the valuation after my other investment principles check out.
This is because valuation determines whether the market is pricing the stock that you’re looking at lower / fair / higher than what it is worth.
So before that, it is important to be comfortable with the stock first by looking at the fundamentals of the stock.
Valuation Methods
There are only 3 methods to valuation:
- Cost approach (Net Asset Valuation)
- Market approach (Multiples Valuation)
- Income approach (Discounted Cash Flow Valuation)
For our purposes, I’ll discuss about cost and market approach.
Income approach requires forecasting of the company’s returns and normal salaryman investors won’t have access to that. Furthermore, it is very tedious work that should be left to the professionals.
Cost Approach
A business has:
- Assets that helps them to generate income and can be sold/cash out for money
- Liabilities that are amount owing to other people and must be paid out at some point
Cost approach is simply taking the total $ value of assets minus total $ value of liabilities. This is called the Net Asset Value.
This also means that we are ignoring the profit generation of the business as we look only to the value of the assets and liabilities of the company.
To assess using this approach, I check either of the following 3 things and the stock is considered undervalued if:
- Book Value per Share is lower than the current share price (Book value = Net asset)
- Price-to-Book (P/B) ratio is less than 1
- Total market capitalisation (share price X total number of shares) is lower than the Net Asset Value
Why? This is because the market is pricing the company at a price that is lower than the value of its assets (after paying off all liabilities).
The 3 methods above can be easily found in financial websites such as Yahoo Finance, Bloomberg. Or for Malaysians – Malaysiastock.biz, i3investor.
Caveat: The company you are looking at need to be a solid company by your other fundamental research (e.g. growth, sustainability, profitability, cash flows, etc)
Market Approach
This is best used in comparison between similar players. The steps are as follows:
- Find all similar players (e.g. Gloves stocks: Top Glove, Hartalega, Supermax, Kossan)
- Determine which ratio to use (commonly Price-to-Earnings (P/E) ratio)
- Compare between the P/E ratio of each of the players to see which one is undervalued as compared to the others
The basis of this valuation is about pricing per $1 profit the company is able to generate. The assumption here is that for companies who are in the same business should be able to fetch the same pricing for every $1 profit it makes.
A company generating more profits will expect to fetch a higher share price as compared to one who earns less.
The P/E ratio of the companies can also be easily found in the financial websites mentioned such as Yahoo Finance, Bloomberg. Or for Malaysians – Malaysiastock.biz, i3investor.
Same caveat as the cost approach is required here.
That’s it?
Yes. That is it.
You don’t need to have a degree or any complicated mechanism at all, unless you are an active trader. Then you will need a whole slew of other skills beyond just valuation itself.
I am not an active trader in the market and hence the above is what I rely on to find a good price to enter.
But you need to understand that valuation is only one part in the context of investing. It only provides you guidance as to whether the stock is fairly valued in the market currently. If the stock has issues fundamentally, like constantly loss making or eroding business, then even if the stock is heavily undervalued doesn’t mean it’s a stock that I’ll invest in.
Good luck and have fun investing!
BONUS: The big glove stocks now are all trading at P/E of over 100 times. This means that if you buy the shares, you are expecting to make back the money through its profits after at least 100 years (assuming no growth). Food for thought… Does that make any sense?
