A strange thing happens during roaring bull markets. When the economy and stock market are booming, investors seem to forget the fundamentals of stock picking. With nearly every stock being carried higher as the major indexes break record after record, investors think that value no longer matters.
But nothing could be further from the truth. Using fundamentals to locate value stocks works in any type of market. While it is more difficult to locate value during times of extreme bullishness, the extra effort can pay off in spades.
Even in the most overstretched market, value cases still exist. Sometimes a company or industry falls out of favor for no apparent reason. A weak quarterly earnings report or an external event can depress a company's stock price for a short time, creating an opportunity for sharp investors.
Here are seven signs a stock could be undervalued.
The current ratio is simply a company's current assets divided by its current liabilities. Value investors should look for a current ratio over 1.50. This assures that the company has enough assets to survive even when bear markets rear their ugly heads.
2. Watch The Debt
When searching for value stocks, debt is a key metric. Using the total debt-to-current asset ratio is how to determine if the company's debt load is too high. Ideally, the ratio should be under 1.10. The total debt-to-current asset ratio can be easily located in a variety of publications or calculated using a company's balance sheet.
3. Positive Earnings
While it goes without saying, I am always surprised at how many stock investors do not consider earnings when choosing value stocks.
Look at earnings over the last five years. Make certain there have been positive earnings per share growth and zero down years within the last five years. If a stock is trading in the value-price zone, yet the earnings growth does not reflect at least five years of positive growth, don't buy it!
4. Technical Price Factors
While I do not think technical analysis makes sense for making trading decisions, it can be a great tool for scanning large numbers of stocks to find those potentially trading in the value zone.
Using a site like StockCharts or your trading platform, scan for stocks trading below their 200-day simple moving average. The further below, the better. This indicates that the share price has been knocked lower and is a good place to start locating stocks for further study.
Another way to help locate value stocks is via Bollinger Bands on daily stock charts. Scan for stocks where the price is trading below or near the lower band as these stocks may be signaling deep value.
As a note of caution, never rely on technical analysis as a stand-alone stock picking or decision-making tool. Always make certain the fundamentals support the technical signals before investing.
5. The Price/Earnings to Growth Ratio (PEG)
The PEG ratio is the price/earnings (P/E) ratio divided by five-year projected earnings growth. If the P/E ratio appears high, yet the earnings are growing quickly, the PEG ratio will show whether the stock is still a good value.
6. Price-to-Book Ratio (P/B)
One of the most critical aspects of value investing is making certain that your stocks have a margin of safety. A margin of safety in this case is the difference between a stock's market price and its estimated intrinsic value. The P/B ratio is the stock price divided by its equity per share. If the number is less than one, the stock is believed to have a sufficient margin of safety.
7. Dividend Yield
A steady dividend yield generally means that the company is throwing off enough cash despite a depressed share price. Since the share price and yield are inversely proportional, always be certain the dividend has been steady or increasing over the last five-plus years. Remember, we are not looking for high dividend yields, but rather consistent yields of a minimum of 1% over some years.
Risks To Consider: Even if a stock exhibits every characteristic of an excellent value stock, there is no guarantee it will be profitable. Always use stop-loss orders and invest defensively.
Action To Take: Practice using the above criteria to locate value stocks for your long-term portfolio.
Editor's Note: Can you read a stock's "tell"? It's the distinctive sign that stocks give just before they take off. We've already made $421,000 using this telltale giveaway. Here's how you can use it too...