In investing, it is desirable for investors of all risk tolerances and experience levels to get an above-average ROI. Some investors achieve this success by investing in mostly blue-chip stocks like Coca-Cola or growth stocks like Amazon.
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However, investors have adopted a strategy of finding stocks that are considered “diamonds in the rough”. They know how to find undervalued stocks. In this piece, we will break down the various nuances that are involved in finding undervalued stocks.
Value Investing: The Basic Concept
Value Investing is an investment strategy in which investors attempt to locate and buy stocks that are trading below their intrinsic values. This style of investing was established in the 1930’s by a financial strategist named Benjamin Graham.
As you will see shortly, there are many nuances to finding undervalued stocks to buy.
Finding Undervalued Stocks
1) Compare P/E Ratios
The first step to finding and potentially buying undervalued stocks is to sort stocks by a metric called the price-to earnings ratio. A P/E ratio is the ratio for valuing a firm that measures the current share price of its stock versus its per-share earnings. Ideally, a comparison of P/E Ratios should be among firms within the same industry.
2) High Dividend Yield
A high dividend yield can be a strong indicator of undervaluation because the stock’s dividend could be high relative to its stock price. Thus, a great dividend yield is critical to choosing an undervalued stock. A dividend yield is considered to be sufficient when it surpasses a benchmark such as the 10-year treasury yield.
A checklist by value investor founder Benjamin Graham suggests that the dividend yield be at least 2/3rd of the AAA Bond yield.
3) Understand the Business
Value investors are more concerned with understanding the details of the business than other stock market factors. Philosophically, value investors are investing in businesses as opposed to stocks undervalued.
Passion is a big factor in understanding a business. If you love the business that you’re investing in, you will have the desire to know all of the company’s nuances. Value investors desire companies with good management and an ownership mentality.
3 Of The Most Undervalued Stocks This Decade
Even though IBM is revamping itself, its value is still quite evident. IBM has managed to outpace the S&P 500 with regards to dividend yield and price-to earnings ratio throughout this decade. IBM’s 5-year price-to-earnings ratio average is 12.9 as compared to the S&P 500’s average of 19.8. IBM shares the same 5-year dividend yield average as the S&P 500.
Dow Chemical (DOW)
In spite of lower revenue, Dow Chemical has managed to achieve profit margin over the course of the decade. Dow Chemical’s 5-year dividend yield average is 1.2% higher than the S&P 500’s average. While Dow Chemical has the same 5-year P/E average total as the S&P 500, Dow Chemical currently has a price-to-earnings ratio of under 8!
Walmart (WMT) is a dual threat in terms of dividend payout and low P/E. This Dow 30 stalwart has had a lower P/E than the S&P 500 in every single year of this decade. Additionally, Wal-Mart’s 5 year dividend yield average is 1.0% higher than the 5-year average of the S&P 500.
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Gilead Sciences (GILD)
Gilead Sciences has a recommendation rating of Buy by Yahoo Finance and is rated five stars by Morningstar. Gilead Science’s P/E ratio of 7.0 is well below its P/E industry average of 43.4%. Additionally, its dividend yield of 2.3 surpasses the dividend yield industry average.
Apple Inc. (AAPL)
Apple Inc is an attractive pick right now thanks to its P/E ratio. Analysts have rated this a buy recommendation as the stock’s P/E is well beneath the S&P 500’s P/E ratio (19.8). It is also slightly below its industry peer group average (13.9) Given the history of success of this stock, there is no doubt about the firm’s intrinsic value.
Alliance Resource Partners (ARLP)
Alliance Resource Partners is a terrific investment that is undervalued and rewards shareholders handsomely. Alliance Resource Partner’s attractiveness lies in its eye-popping 10% dividend yield.