THE STOCK MARKET HAS taken investors on a wild ride this year.Whether you're looking for a short-term investment or want to make strategic buys for long-term holdings, you'll need to know whether a stock is undervalued, overpriced or a value trap. Here are three tips to keep in mind when you're trying to find an undervalued stock:
Know Your Intent
If you're looking for short-term, momentum-type trades, these could be considered value traps because they don't show much volatility and investors are unlikely to see any quick price appreciation.
Consider P/E Ratios
When Person evaluates potentially undervalued stocks, he looks for shares that are breaking out of their trading range.
He compares a stock's relative performance to the S&P 500. If the stock is outperforming the broader market, he then reviews the company – looking at its business model and what it does. He reviews its price-earnings metrics and compares that information to its peers and the broader market.
In general, Person prefers companies with low P/E ratios and stays away from companies with high P/E ratios.
Considering how much technology has impacted companies across sectors, when it comes to finding undervalued companies, investors also need to look at a company's management team to see if they have a track record of adjusting or adapting to disruption.
Look at Dividends
Michael Skillman, CEO of Cadence Capital Management, says his firm uses dividends to discover undervalued stocks. He finds dividends more useful than other traditional fundamental measures such as price-to-book ratio, discounted cash flow, P/E ratio and intrinsic value.
Specifically, he looks at price-to-dividends ratios when trying to determine a company's valuation. "Dividends are a company's ability, after funding their growth, to return capital to shareholders," Skillman says.
He says companies are loathe to cut dividends because shareholders depend on that steady increase in income. If a company has a distribution greater than the S&P 500's average dividend, which he calls "premium income," investors should dig into the company's financials to make sure it can continue to pay that distribution consistently.
That's critical because some companies will boost the dividend payment to attract investors, but the payment may not be sustainable. Skillman says during the first-quarter market sell-off, companies with artificially high dividends were some of the worst performers compared to companies that didn't pay a dividend or had a lower dividend.
That's unusual because most dividend payers do well in market downturns, but the pullback revealed these dividend payments were likely unsustainable.
Specifically, Skillman says the fall in some high-dividend-paying names was very evident in energy companies, for example, because investors were shying away from companies with cyclical exposure and high debt levels.