You have read the Wall Street Journal and other online publications about undervalued stocks, but what exactly is an undervalued stock and how do you find them?
An undervalued stock is one that is trading below its intrinsic value. What does that mean? Just because a stock is valued at say $50 a share, doesn’t necessarily mean that’s what it is worth. We saw many stocks like Bear Sterns and Lehman how they were priced high, but value wise collapsed. You can also find stocks trading at $50 but are perhaps worth $60, $70 or more because they have assets that the market is under pricing. These are the companies we should be looking for to invest in.
Another way to determine if a stock is undervalued is by trying to determine its future cash flow. This is one of the ways Warren Buffett looks for stocks. Warren Buffett is perhaps the greatest value investor of all times. So it would be wise to follow how he looks for undervalued stocks.
One of the first things you need to look at is the financial stability of the company. Look at its track record of earning and profits. Has there been a steady increase in profits over the years, or have there been large peaks and valleys of earnings. What you want to look for is a dependable source of income and earning each year. Is the company a leader in its field? Warren Buffett likes to find businesses with what he calls a moat around them. He doesn’t like to invest in companies where there is an easy entry into that field. This is one of the reasons he doesn’t invest in the Internet. The barriers are quite low to enter. For example remember when Yahoo was the top search engine? Remember Lycos and Alta Vista? They were big companies, but then Google came along.
Warren Buffett has recently invested in railroad transportation. This is a good example of a business with a moat around it. Nobody is suddenly going to build a railroad to haul goods overnight.
So a good stating point when looking for undervalued stocks is its balance sheet to make sure its earnings and profits are on a steady trajectory up and if there is a high barrier for competitors to enter that market.