How to find undervalued stocks in 2020

April 24, 2020 11:30 UTC
Reading time: 15 minutes

Identifying undervalued stocks - companies whose share price is trading below its 'fair' value - has long been the quest of hedge fund managers, legendary investors like Warren Buffett and individual traders and investors alike. But of course, finding high-quality undervalued shares and buying them in the hope of trading them back to 'fair' value requires some know-how.

In this article you will learn:

  • What undervalued stocks are.
  • The secret to finding undervalued stocks.
  • The most important financial ratios to find the 'fair' value of a company.
  • The top stocks of 2020 and how you can trade them.
  • How to get started by opening a risk-free demo trading account with Admiral Markets UK Ltd to practice your ideas and theories in a virtual trading environment.

What are undervalued stocks?

An undervalued stock is a publicly-traded company whose share price is lower than its 'fair' value. You are probably thinking how a company can ever get in that situation as surely a large hedge fund or investor in 'the know' will have snapped up the undervalued shares pretty quickly. The reality is that there are many different reasons why a stock could be undervalued, such as a:

  • Market crash: In a market panic investors typically think emotionally rather than rationally. This means panic selling can cause a decoupling between an asset's current price and 'fair' value.
  • Company-specific problem: There are times when a company may go through some issues caused by negative news, fraud, a scandal or even political and economic changes. This means the company's share price may drop significantly if investors choose to sell and invest elsewhere until the problem gets resolved.

Investors would typically use these scenarios to buy undervalued shares due to the fundamental assumption that the share price will correct back to the asset's 'fair' value over time. However, an undervalued stock is not necessarily just any stock that is cheaper than it was before. The key is to look for high-quality stocks whose share price is under its 'fair' value, rather than just at a low price.

A good example would be to use the investing ethos of legendary investor Warren Buffett. Dubbed the 'Oracle of Omaha', Buffett learnt his trade from the 'father of value investing' Benjamin Graham. Their ethos is to buy undervalued stocks of high-quality companies that will grow over the next five, ten and 15 years.

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How to find undervalued stocks

There are a variety of ways to find undervalued stocks. The most common fall into a form of fundamental analysis or technical analysis but usually a combination of both.

There are two types of fundamental analysis: a top-down analysis and bottom-up analysis. In a top-down analysis, an investor would first analyse the bigger picture or the broader economic trend before finding companies that could perform well in such times. The bottom-up approach involves analysing a company's fundamentals first and then looking at the bigger picture.

Technical analysis is quite different and only involves the analysis of a company's share price. Traders would typically look for repeated chart patterns and use technical indicators to find suitable stocks to trade on.

Nowadays, most traders use a combination of both types of analysis. However, when identifying undervalued stocks there are some very specific financial ratios and metrics investors like Warren Buffett and Benjamin Graham would use. Let's take a look at some of these.

# 1 Price to earnings ratio (P/E)

The price/earnings (P/E) ratio compares a company's stock price against how much profit the company is making. It is one of the most popular ways to measure a company's value.

The P/E ratio is calculated by taking the current price of a stock and dividing it by the company's earnings-per-share number. A low P/E ratio could mean the company's stock price is undervalued. This is because you're paying less (the price) for the amount of profit the company is generating (the earnings).

While the ratio by itself is a useful metric it becomes more powerful when compared to the industry average. For example, the P/E ratio of an energy company like British Petroleum (BP) would be compared to the P/E ratio of other energy companies like Royal Dutch Shell. If a company's P/E ratio is below the industry average it could be a sign the stock price is undervalued.

# 2 Price to earnings growth ratio (PEG)

The price to earnings growth ratio (PEG) looks at the P/E ratio compared to the percentage growth in annual earnings per share, usually for the next five years. This gives investors a sense of the company's future earnings potential.

PEG is calculated by taking the P/E ratio and dividing it by the expected annual earnings per share growth rate. Investors would typically look for a company with a low PEG as these companies are considered as undervalued. The PEG ratio is typically seen as a more reliable indicator when trying to identify undervalued stocks.

# 3 Price to book ratio (P/B)

The price to book ratio (P/B) is used to measure a company's stock price to the company's book value. A company's book value is the value of its assets minus liabilities, divided by the total amount of shares issued.

The P/B ratio is calculated by dividing the company's market price per share by its book value per share. This tells the investor how much money they would get if the company was liquidated. Investors would typically look for a P/B ratio of between zero to one to indicate a potentially undervalued company.

# 4 Return on equity (ROE)

The return on equity (ROE) ratio measures a company's overall profitability against is equity. The ratio is calculated by dividing the net income of the company by its shareholder equity. The outcome is a percentage based figure.

A high return on equity (ROE) figure shows the company is generating a high income relative to the amount shareholders have invested. In this scenario, the company would be deemed as potentially being undervalued.

# 5 Dividend yield

The dividend yield is a popular quoted financial ratio. It is used to describe the ratio between a company's annual dividends and its share price. Dividends are the portion of profits which are paid to shareholders.

To calculate the dividend yield, you simply divide the annual dividend by the share price. Company's with solid dividend yields are more likely to be stable and return profits to shareholders. You can learn more about dividends in the ' Best Dividend Stocks for Income' article.

Before we look at three undervalued stocks for 2020, did you know that you can download the MetaTrader 5 trading platform provided by Admiral Markets completely FREE? Simply click the banner below to start your free download and access real-time and historical price data on multiple asset classes including stocks, indices, commodities, currencies and more!

Three undervalued stocks for 2020

Due to the impact of the coronavirus, nearly all stocks crashed lower in the global stock market sell-off in March 2020. This shake-out has led to some high-quality companies now trading at undervalued levels, far away from their 'fair' value. Below are just a few to consider for 2020.

#1 Boeing

Boeing (BA) was once the most successful company in the United States. However, the aerospace giant has had a very tough 2020. In fact, nearly all air travel companies have been affected by the coronavirus lockdown. While most of these stocks are lower, Boeing shares have dropped more than 70% in 2020 alone.

This has led the company's share price to be trading at a price to earnings multiple of just 6.5 which - according to this ratio - means the stock is undervalued. However, the key to value investing is to find high-quality companies that can move back to its 'fair' value.

Boeing only has about $10 billion of cash on its balance sheet causing some investors to fear the giant may have to enter insolvency. For many investors though, a lifeline from US President Donald Trump could help the company navigate the coronavirus-led sell-off. At the time of writing, the company and government are still pondering a potential bailout so it may pay off to wait until there is more clarity around this.

Below is the long-term, monthly price chart of Boeing's share price:

Source: Admiral Markets MetaTrader 5, #BA, Monthly - Data range: from 1 April 2007 to 23 April 2020, accessed on 23 April 2020 at 11:22 am BST. Please note: Past performance is not a reliable indicator of future results.

The price chart above shows the huge decline in Boeing's share price. However, it also shows the share price stabilising at the $106 price level which is also a strong horizontal support level where buyers have turned up before in 2015. Traders would often use these type of levels to trade from, as well as target.

It's a long way back up to Boeing's all-time high price level but this could be a starting point for buyers to build from.

#2 General Motors

General Motors (GM) is an American multination company that is home to car brands such as Chevrolet, Buick, GMC and Cadillac. The company which is headquartered in Detroit manufactures vehicles in 15 countries.

The auto industry is very cyclical with higher car purchases in the summer than the winter. The impact of the coronavirus has stalled large purchases as more individuals lose their jobs or become furloughed. However, there are reasons why investors may consider General Motors as an undervalued stock.

Firstly, the company has a low P/E ratio of 4.70. Secondly, its dividend yield is around 7.2% (at the time of writing). This means regardless of what happens to the stock price investors will receive 7.2% interest a year in the form of dividend payments.

Below is the long-term, monthly price chart of General Motors' share price:

Source: Admiral Markets MetaTrader 5, #GM, Monthly - Data range: from 1 November 2010 to 23 April 2020, accessed on 23 April 2020 at 1:22 pm BST. Please note: Past performance is not a reliable indicator of future results.

The above price chart of General Motors' historic share price shows that the stock price is trading in between a long-term consolidation chart pattern, as denoted by the upper black horizontal resistance line and lower black horizontal support line. Some traders may well use this lower support line to start building positions in a potential turnaround in the company.

#3 Carnival

Carnival (CCL) is a British-American cruise operator who currently has the world's largest fleet with over 100 vessels across 10 cruise line brands. As governments enforced the 'non-essential travel' restriction due to the coronavirus, cruise line companies and most other types of travel and leisure companies felt the pinch.

In fact, Carnival's share price has been in a steady decline since the beginning of 2018, falling nearly 90% lower. However, the situation presented by the coronavirus is forcing companies to change business structures and models, leaving the bigger players in an industry to take control.

If Carnival can survive the crisis, it could be in a good position to lead the way higher as demand picks up, although this is a long-term situation. With a price to earnings ratio of just 2.8, it is considered undervalued by investors.

Below is the long-term, monthly price chart of Carnival's share price:

Source: Admiral Markets MetaTrader 5, #CCL, Monthly - Data range: from 1 October 2000 to 23 April 2020, accessed on 23 April 2020 at 2:22 pm BST. Please note: Past performance is not a reliable indicator of future results.

Another great resource to help with your own technical and fundamental analysis is the Trading Central Technical Insight™ indicator. This provides actionable technical analysis for a wide variety of asset classes and it can be downloaded completely free by upgrading your MetaTrader 5 trading provided by Admiral Markets.

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How to trade undervalued stocks

To start trading undervalued stocks you first need to open a live or demo trading account and then download your free MetaTrader 5 trading platform. To start trading, follow these steps:

  1. Open your MetaTrader 5 trading platform provided by Admiral Markets.
  2. Open the Market Watch section by selecting View from the top menu or by pressing Ctrl+M on your keyboard. This will then open a list of instruments on the left side of your chart.
  3. Right-click on the Market Watch window and then select Symbols. Alternatively, press Ctrl+U on your keyboard. This will open a window, as shown below, which details all the markets available for you to trade on.
  4. You can either select an individual symbol or search for it in the search box. After pressing OK the instrument selected will be shown in the Market Watch window.

Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

To view your instrument on the chart, simply drag it from the Market Watch column onto the chart. Now you can open up a trading ticket:

  1. Right-click on the chart.
  2. Select Trading.
  3. Select New Order, or press F9 on your keyboard.
  4. A trading ticket will open for you to input your entry price, stop loss and take profit levels and unit size (volume).

Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

To learn more on how to buy and sell undervalued stocks, open your free MetaTrader platform and then watch the video below:

Why trade undervalued stocks with Admiral Markets?

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  • Access the fastest and most popular online trading software, MetaTrader, for FREE which you can use on PC, Mac, Web, Android and iOS operating systems.
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Get started today by opening a free demo trading account so you can trade in a virtual trading environment until you are ready to go live!

About Admiral Markets

Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or recommendation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

Jitanchandra Solanki
Jitanchandra Solanki Financial Markets Author, Admirals London

Jitanchandra is a financial markets author with more than 15 years experience trading currencies, indices and US equities. He is an accredited Market Technician with a BA Hons degree.