Stock Valuation: 6 Powerful Financial Ratios to Find Undervalued Stocks
Today I am going to show you how to do a complete stock valuation and how to find undervalued stocks!
In fact, we will look at 6 very simple financial ratios. They will help you to identify high dividend, undervalued stocks for long-term investments.
Yet, before investing even into an undervalued stock, don’t you want to make sure the company is a good choice? Click here to see how a complete fundamental analysis is done.
So let’s assume we know that the company we are looking at is stable, profitable, and growing. According to the 5-step framework for financial analysis we now have to perform the stock valuation.
More specifically, that means we look at the stock market performance of the company. In general, we are interested in the most important metrics relevant to investors. Those, that tell us something about the returns to investors and the stock valuation.
On the one hand, we want to make sure the dividend satisfies and provides us with our expected return. On the other hand, we want to make sure that the stock is not overvalued and we do not pay too much.
Therefore, we are looking at the 6 most important stock valuation metrics that tell us how to find undervalued stocks:
- Dividend Yield
- Dividend Payout Ratio (DPR)
- Earnings per Share (EPS)
- Price-to-Book Ratio (P/B Ratio)
- Price-to-Earnings Ratio (P/E Ratio)
- Graham Number
Dividend yield simply tells you how high your return per share is. It is of major importance for long-term value investors. This is because they are usually holding high dividend shares to earn a passive income on dividend yield.
Of course, you want to get the most out of your investments. Further, you want to get a better return than from other investments, such as bank deposits, bonds, etc. By taking the dividend yield, you can compare the benefits from holding a stock from two different companies.
However, you should be aware that there are also quite famous companies that do not pay out a dividend at all. For example, Amazon, Ebay, Netflix, … If you want to know why, read this article from The Motley Fool.
Now you wonder, which is the best or minimum yield a stock should return? Of course, there is no straightforward answer. It always depends on your risk adversity. However, as a rule of thumb you can start with the long-term inflation target, which is 2%. To make money, thus, you should at least aim for a dividend yield of 2% or higher.
I usually aim for high dividend yield stocks with a yield of at least 3%. Again, more is always better as long as the remaining company characteristics and financial ratios are fine as well. In addition, the dividend yield should be sustainable. It does not add value if you get 7% in one year and nothing in 5 subsequent years. Rather, you want to have steady dividend payouts that do not decrease but show room for upward improvement.
Thus, in addition to a decent level of dividend yield, make sure the company has been paying out dividends for at least a few (5-10) consecutive years.
Done with the first step of stock valuation, let’s look at the second one to find undervalued stocks…
Dividend Payout Ratio (DPR)
The dividend payout ratio gives us the total dividends paid out to shareholders relative to the company’s total income. Now you wonder why you should bother about total dividends, right?
I think the dividend payout ratio is one of the most underrated financial ratios! Especially for long-term oriented value investors. The reason is quite simple: money that is not paid out to investors is kept within the company. With this money, a company can create reserves, invest in machinery, infrastructure, or human capital.
In any case, the remaining money is used to secure and build the future of the company. Therefore, you should definitely care about a company’s dividend payout ratio.
A simple rule of thumb is to look for companies with a moderate dividend payout ratio at around 30%-45%. Of course, they should provide a good dividend yield at the same time.
Let’s take the example of BMW. They explicitly state that they aim for a dividend payout ratio of 30%-40%, which they have been achieving within the past 6 years. Thus, at least from only looking at DPR, BMW would definitely be a suitable company to invest in.
Earnings per share are an indicator for a company’s profitability. The financial ratio shows how much a shareholder of a common stock would get if the company would pay out all of its profit.
Again, this is a financial ratio you can use to check the stock’s consistency over time. Make sure the company has had positive earnings per share for the past 5 to 10 years. If you want to be more conservative, check if earnings per share have been growing at least one-third within the past ten years.
Let’s check out what the next step in stock valuation is, to eventually find undervalued stocks…
Price-to-Book Ratio (P/B Ratio)
The price-to-book ratio compares stock market valuation to the book value of the company. It tells you what an investor is willing to pay for one dollar of a company’s assets. More specifically, it tells you what value the market attaches to the company’s assets compared to their actual book value.
The reason why you should compare a market driven opinion to an accounting-based opinion is simple. Generally, market participants formulate an opinion about a company and have specific expectations regarding its future profitability and earnings. These expectations are reflected in current stock prices.
For example, if the market expects the company to grow and be highly profitable in future, investors will buy its shares. By that, the stock price is going up and thus, the company’s market capitalization goes up as well. However, a company’s market valuation is only one side of the coin. The other is the actual book value of the firm. A company’s book value is simply the actual value of the company’s assets as indicated on the balance sheet. For a manufacturing firm, assets can comprise anything from tangible to intangible assets. Respectively, this might be machinery, inventory, non-finished goods or patents and other intellectual property.
Most often, there is a difference between a company’s market value and the actual value of its assets. Depending on the extent and the direction of the difference, a company can either be overvalued or undervalued.
If the price-to-book ratio is below 1, a company is undervalued. Simply because the standalone assets are worth more than the currently attached market value. However, be aware that there might be distortions between highly asset intensive companies and lower asset intensive ones.
Price-to-Earnings Ratio (P/E Ratio)
The next powerful financial ratio is the price-to-earnings ratio. This is highly effective in finding undervalued stocks when performing a company’s stock valuation.
Price-to-earnings ratio is very similar to price-to-book ratio. Yet, it’s still different and provides us with additional information.
The price-to-book ratio tells you what an investor is willing to pay for one dollar of a company’s earnings. Obviously, it is more up to date than P/B ratio. That’s because earnings reflect the current business much better that the (sometimes quite old) book value of assets.
To get a better feeling about the level of a company’s price-to-earnings ratio, you should always compare it to some benchmark. That could either be an industry benchmark, major competitors, or your watchlist of companies. Also, be aware that companies have different capital structures influencing earnings. If you want to know more about the effects of financial leverage, read the paragraph about debt/equity ratio in this article.
Ideally, you should aim for a moderate price-to-earnings ratio that should not be more than 1 times the average earnings for the past three years.
Finally, let’s conclude with the last step of our stock valuation…
The Graham number was initially described by – of course, you have guessed it – Benjamin Graham. He wanted to come up with a financial ratio that tells you something about a stock’s fair value.
Specifically, the Graham number indicates the upper boundary of a price range for a stock that a rather conservative investor should be willing to pay for the respective stock. For example, Amazon’s Graham number was $143 as of September 2018. Back then, you shouldn’t have paid more than $143 for one Amazon stock. If the stock price was above the Graham number, the stock was overvalued and vice versa.
No doubt, the Graham number is great. However, with my approach to stock valuation I want to provide you with a single number that helps you to find undervalued stocks… And this is the Graham number to share price.
The Graham number to share price is another powerful and simple financial ratio. You just have to divide the Graham number by the current share price. With that you come up with the Graham number to share price.
This financial ratio tells you, if the stock is currently undervalued or not. It simply compares the Graham Number (i.e. the stock’s fair value) with the current stock price. If the resulting value is below one, the stock is obviously undervalued. It you come up with a value above one, the stock’s overvalued.
There is another great advantage of the Graham number to share price. It’s the ability to create time series analysis. That’s simply looking at development of the Graham number to share price over a period of time. You simply calculate and plot the Graham number to share price and the share price itself in a chart. Then, you can see in which periods the stock was undervalued or overvalued. Maybe, you might be able to spot an underlying pattern or interesting developments. See below for an example of a Graham number to share price time series analysis.
Final Thoughts on How to Perform Stock Valuation and Finding Undervalued Stocks
There you go: stock valuation in 6 easy steps that help you to find undervalued stocks!
Now I would like to hear from you..
Which stock are you going to analyze first? Do you think you will find some good investment opportunities? Maybe you are even going to use additional financial ratios?
Either way, let me know by leaving a comment below right now.
Thanks for reading this article. Please, let us know if you have feedback, corrections, or any further question (either down below in the comments or via contact). We are happy to discuss and further support you along your way to becoming a “yield reviewer”
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