Undervalued Stocks: What They Are and How to Find Them

Undervalued stocks are often traded below their believed market value. Here's how to find them, and what makes them attractive to investors.
Jun 2, 2022

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What are undervalued stocks?

Undervalued stocks are stocks that trade below their assumed value. They often have a track record of being profitable, and the potential for long-term growth, but the stock market hasn’t recognized that yet.

“I think about something that I love going on sale,” says Ali Swart, a CFP at Waldron Private Wealth, based in Pittsburgh, Pennsylvania.

For instance, if you shop a sale and see something is worth $100 but goes on sale for $75, that could be considered undervalued. Likewise, an undervalued stock trades below what it's worth.

Why are stocks undervalued?

Sometimes, stocks are undervalued because they’re pulled down by their sector or the overall market, says Daniel Milan, managing partner of Cornerstone Financial Services in Southfield, Michigan. However, the companies of such undervalued stocks usually have strong balance sheets, good net free cash flow and a strong future outlook.

“One example could be Qualcomm — which has been pulled down with the overall tech sector — but even more specifically, within semiconductors, it's often been overlooked on its own. But it's trading at a greater discount in comparison to its peers,” Milan says.

There are downsides to hunting for undervalued stocks. There may be a reason the stock is trading below value, and that reason may not be readily apparent. For example, the company could have core issues like unexpected changes in the company structure or maybe issues with financial management.

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How to find undervalued stocks

If you’re looking for undervalued stocks, there are strategies you can use. A general principle is to ensure individual stocks don’t make up more than 10% of your portfolio.

1. Look at the company’s price-to-earnings ratio and market cap

One way to find undervalued stocks is by looking at a stock's price-to-earnings ratio, also known as PE ratio. The PE ratio is calculated by dividing the company’s stock price by its earnings per share. To find the earnings per share of a company, divide its earnings from the past 12 months by the number of shares issued and held by stockholders. If you find a company’s stock has a lower PE ratio, there’s a chance you could be getting valuable stock at a discounted price.

In addition to looking at the PE ratio, a company’s market capitalization — or market cap — can also give you insight into the true value of a stock. Market cap is the total value of a company’s shares of stock, and it can tell you how profitable a company is. You can calculate the market cap by multiplying the current price of a single share by the total number of shares held by stockholders.

2. Target undervalued sectors

You could also consider looking at specific sectors of the market while hunting for undervalued stocks.

For example, if tech stocks are on the decline, you could look for companies that have declined along with the rest of the sector, but still show potential for strong growth over the long term.

3. Do your research

Use your brokerage firm’s stock screener to narrow your search and find opportunities. A stock screener is a tool that makes it easier for you to sort through stocks by using specific search criteria. You can find stock screeners at brokerages such as Fidelity, as well as on platforms like Morningstar and Yahoo Finance.

Before choosing to invest in a stock, think about why you’re choosing it, because your "why" will carry you through market volatility. Also consider applying Warren Buffet’s advice of only investing in what you understand.

» Take a look at our list of free stock screeners

4. Explore emerging industries

Undervalued stocks aren’t just those that have seen a price dip. They could be those of a company in a new or emerging industry that isn’t mainstream yet, so consider that in your search, too. You could also play it safe by buying only a few shares and watching how your investment progresses over time.

» Learn about how to buy stocks

When undervalued stocks become popular

Undervalued stocks can become more attractive to some investors in times of stock market volatility, says Milan.

The companies whose stock is undervalued may have strong cash flow and balance sheets. So even if the prices dip, investors buy because they’re getting what they believe to be valuable stock for less money before prices shoot up.

Undervalued stocks can also become popular when a promising company experiences exponential growth but experiences some volatility or dips in price. Tesla is one example of this, says Swart. They pioneered an industry for electrical vehicles, which is an emerging technology that had growth potential. Tesla made its initial public offering in June 2010 at $17 per share. Then by March 2011, its shares were sold at about $4 a share. At this point, the stock could be considered undervalued and could be more attractive to investors who saw the company's potential.

Fast forward to 2022, and Tesla was trading above $600 a share. So investors who bought in when the price was around $4 a share reaped the benefits of undervalued stocks that end up doing well in the long-term.

All investing comes with risks, and undervalued stocks carry risk, too. You could invest in something like Tesla and make massive gains … or not. Some companies that have undervalued stock don’t end up succeeding, and sometimes investments further depreciate or take longer to decrease in value. If you’re not quite sure about a stock, consider talking to a financial advisor.

Next steps: 

» Looking for cheap stocks on the rise? Here's how to find them 

» Learn everything you need to know about recession-proof stocks

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