Finding great stocks is not easy nowadays as there are so many great options and different selection criteria that it becomes very difficult sometimes to choose interesting shares from companies that look strong fundamentally. After reading this guide you will understand what is undervalued stock and how, using the most important fundamental indicators, choose best undervalued stocks to buy now.
What is undervalued stock?
Undervalued stock is a stock that has a target price higher than its current market price. I usually choose stocks with target price at least 20% higher than the market price, When the target price exceeds the market price, investment analysts and traders think that the company is trading at a discount based on forecasted financials.
Is the target price enough?
But not only that, traders should also look at other fundamental indicators such as EPS surprise, social sentiment, analyst ratings, Piotroski score, and dividend yield to pick really great shares, that not only look undervalued but also have strong fundamentals. We will consider all of those indicators in more detail. But first you may ask why we need to examine all of those indicators? Good question. We do it to make sure the stock is strong fundamentally, because if it is strong it will always have strong support and if the stock starts falling, it will rebound fast as institutional investors always try to pick great value shares with strong fundamentals as soon as such stocks experience sharp decline.
Now when you know why you need to pick undervalued stocks with strong fundamentals, let's consider all the components of a great stock in more detail. Let's take one stock as an example and go through all the indicators using this stock. I will also be using one valuable iOS application Stocks 2 Buy that will help me find best undervalued stocks to buy now. You can proceed without the mentioned application and manually collect/calculate data, but the app makes it easy and saves your time. Before we begin, lets consider how to calculate stock target price in order to find undervalued stocks.
How the stock target price is calculated?
To calculate the stock target price, investment analysts and traders can use different equity valuation models, such as the Discounted Cash Flow model or DCF. Where analysts forecast companies' Free Cash Flow (FCF), calculate the company's terminal value and discount everything by the WACC or discount rate. Another equity valuation model is the Dividend Discount model or DDM. This model forecasts companies' future dividends and terminal value per share, discounts everything by the cost of capital, and comes to the stock fair value. The DDM model can only be used with companies that regularly pay dividends. Another popular model is the price/income or multipliers model, where you compare companies' ratios to industry peers' averages, come up to the coefficient, and then calculate the stock target price based on financial ratios that you choose. Traders can choose one of the models, or combine all three in calculating stock fair value (stock target price) and then come up to the average number (average between all three models).
After calculating the stock target price, compare it to the stock's current market price. If the target price is at least 20% higher than the market price, then the stock is currently trading at a great discount and its price can skyrocket soon if the company's actual financials will be in line or better than your expectations and assumptions that you put into your model. But your analysis is not finished yet, after calculating the stock target price and finding a stock with a target price exceeding its market price, it's time to analyze other fundamental indicators to make sure you are holding the best stock among closest peers. It's a good practice to compare your chosen stock and its indicators (indicators that we will talk about) to closest peers to pick truly amazing shares that outshine its peers. Now let's consider other important indications that can help you define a strong share.
Finding best undervalued stocks to buy now. Part I.
We will take one interesting share as an example, Ovintiv Inc with the stock ticker OVV. Ovintiv Inc is a prominent player in the energy sector, primarily engaged in the exploration and production of oil and natural gas. Before we begin our journey into finding great shares to buy now, download the Stocks 2 Buy app from the app store, register, log in, and then input the stock ticker OVV in the Main Screen and press the Show analysis button. This will be the first stage of our analysis. As you can see from the picture below, the app shows us EPS surprise, social sentiment (stock sentiment), and equity rating. Now let's consider what those numbers mean in more detail.
What are EPS and EPS surprise?
EPS stands for Earnings Per Share. It's like figuring out how much money each share of a company makes. You take the company's total earnings (net income) and divide it by the number of shares.
EPS Surprise happens when a company's actual EPS is different from what investment analysts forecasted it to be. If the EPS is better than what analysts thought, it's a positive surprise. If it's worse, it's a negative surprise. This can make the stock price go up or down because investors like surprises.
Why EPS surprise is important?
Pick companies with higher EPS surprise (when comparing to closest peers) and also companies that constantly beat EPS forecasts (at least 3 or more quarters). This can mean that there is a high probability that the company will show better than expected financials on the next reporting period, resulting in share price going upwards. That's why it's important to be ahead of these movements and find shares with high EPS surprise.
EPS numbers from the above example.
The above example shows that the company's actual EPS is 62% better than the forecasted number. This is an amazing result which means that analysts can adjust and improve their forecasted numbers for the next reporting period, and also good EPS surprise can bring more institutional investors to the stock.
What is Social Sentiment?
Social sentiment helps traders understand what the public thinks of their selected stock. The sentiment is mainly collected from social media and counts the number of positive and negative mentions of the stock. The number is usually between 0 and 1 or 0 and 100%. A number of 0.6 or 60% for example can mean that the stock has more positive mentions but still they are close to neutral (almost equal to negative). A sentiment of 0.8 would mean that the stock has more positive mentions on social media.
Why social sentiment is important?
Social sentiment is important because it can move stock price in the shorter term. For example, a high number of positive mentions increases traders' optimism and drives stock price upwards. A declining stock with lots of positive mentions would rebound quickly as traders will pick the great share quickly. Negative mentions from the other side (0.3 sentiment for example) can lead to panic selling in the shorter term and a rising stock can turn into a falling stock quickly.
Social Sentiment numbers from the above example.
From the above example, the social sentiment is 0.25, meaning that the stock is mentioned more in a negative or pessimistic key, indicating that shorter term downside probability may pressure the stock but since it has great EPS surprise, the stock can have a raising mid-term trend.
What is Equity Rating?
Investment analysts assign stock ratings based on their fundamental analysis and stock fair value calculation (stock target price calculation). The stock rating can be neutral, buy, sell, strong buy, or strong sell, reflecting analysts' opinions towards some particular stock.
Why Equity Rating is important?
A strong buy rating can indicate that analysts are optimistic about the stock and expect numbers to skyrocket and improve significantly, whereas a sell or strong sell rating can indicate that analysts are skeptical about future stock positive growth dynamics until the company improves its fundamentals.
Equity Rating from the above example.
From the OVV company example, the Stocks 2 Buy app shows the Neutral equity rating. It means that some analysts have a buy rating and others have a sell or hold rating. The app shows the average rating among investment analysts which is neutral. It means that if you bought the stock, keep holding it as it may still surprise you in the future, however, if you did not buy it yet, it may be a good time to wait a bit, until sentiment changes to positive (above 0.6).
If you are using the Stocks 2 Buy app and analyzing the stock, the Main Screen provides mid-term trade recommendation based on social sentiment, EPS surprise, and equity rating analysis. The app provides a summary of those indicators and tells if it's a good idea to Sell, Hold, or Buy the stocks. Since the app has great EPS surprise and provides mid-term recommendations, it is saying that it can be a good opportunity to buy the stock if you are planning to hold it mid-term, however, low social sentiment tells that it may have some space for downside on the shorter term. However, this can create an even better opportunity to buy the stock even cheaper and hold it mid-term.
Finding best undervalued stocks to buy now. Part II.
Now we finished the first part of our analysis. The next part is to analyze stock target price, dividend yield, stock growth dynamics, and Piotroski score to spot truly amazing shares. To do that, we will again be using the Stocks 2 Buy app, but you can extract those numbers manually if you want. In the Stocks 2 Buy app, go to the Stock Type screen, input the stock ticker OVV, and press the Analyze button. Let's see the result that the app shows us.
This screen defines the stock type, which is a Value stock because it has great growth potential of 25% (target price exceeds its market price by 25%). You already know how to calculate the stock target price. You can do it manually using your custom assumptions or use the Stocks 2 Buy app that calculates the stock target price using conservative assumptions. The stock also has a great Piotroski score of 8, making it a great value share.
The app also gives you suggestions on when is the best time to buy this share. In our case, it's a good long-term hold idea, due to strong fundamentals and great financials. Now let's consider in more detail those indicators and you will understand why this app is a great buy value stocks and a great long-term hold idea.
What is a Piotroski score?
The Piotroski Score is like a financial health checkup for companies. It's a number from 0 to 9 where higher scores mean better financial health. It looks at nine different aspects like profitability, debt levels, and how well a company uses its assets. Investors use this score to spot stocks that might be good buys because they're financially sound.
What Piotroski score of 8 from the example tells us?
A high score indicates that OVV is managing its resources effectively, maintaining operational efficiency, and is likely to sustain its performance in the future. OVV's Piotroski Score of 8 out of 9 highlights its strong financial health.
Stock target price and amazing growth potential.
OVV's strong growth potential of 25% tells us that analysts are optimistic about the company's ability to beat EPS and FCF expectations, leading to higher value in the future. 25% growth potential also tells that the stock is currently trading at a high discount (undervalued stock).
What dividend yield tells you?
Dividend yield is like the interest you get on your savings, but for stocks. It tells you how much a company pays out in dividends each year compared to its stock price. You figure it out by taking the annual dividend per share and dividing it by the stock's current price, then multiplying by 100 to make it a percentage. OVV's dividend yield of 2% is good but not high (consider dividends of above 4% as high) but can be a good bonus for holding a share for a longer term.
The Stocks 2 Buy app also shows stock dynamics in the last 3 and 6 months. By looking at these numbers, you can tell if the stock touches its local minimum or not, or if the stock is raising aggressively. If the stock was raising in the past 6 months but declined in the past 3 months, this can mean that the stock touched its local minimum and it can be a great opportunity to buy the share if it has strong fundamentals (target price and Piotroski score). The OVV example tells us that the stock declined in the past 6 months but gained 12% in the past 3 months, driven by good EPS numbers and stock growth potential (high target price). If you compare stock growth dynamics to the industry average, you can conclude that the stock still has good growth potential as 12% is low growth potential in the current environment; however, a shorter-term correction is possible.
By employing important fundamental indicators, you can find amazing shares and the best undervalued stocks to buy now. From our example, OVV is a strong stock that looks amazing fundamentally, with a strong Piotroski score of 8 out of 9, high growth potential of 25% which suggests that the stock is undervalued, good EPS surprise, and slower growth in the past 6 months that suggests that the stock has amazing space for upside. However, based on the social sentiment and neutral analyst rating, the stock may experience shorter-term downside within a few months but has strong fundamental support in the mid and long term.
I hope my guide was useful and now you have great tools and indicators for finding the best undervalued stocks to buy now. Please keep in mind that company financials change regularly, that's why it's recommended to regularly check your calculations and company financials to make sure it is still strong and aligns with your risk appetite.
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