How do you buy an undervalued stock that might jump up in price?
Various models have been derived to calculate market mispricing of stocks. Benjamin Graham, one of the founding fathers of value investing, had a simple calculation for determining intrinsic value versus the market, and he bought at a margin of safety when Mr. Market low-balled prices. (Also read here about 16 undervalued stocks Graham may have bought.)
Other methods use current and future expected earnings per share, amongst other data, using the Bakshi-Chen Dong model (1998), which provides a window of how far a stock is deviating from its historical valuation average. This allows for a wide range of price to earnings values -- even very high ones -- as it's more of a relative measure than the absolute method used by Graham. Bakshi-Chen Dong also found that high momentum stocks, or previous price winners, enhanced the reliability of the BCD mispricing model.
Our stock screen here will attempt to find share prices that have a positive momentum. We want book value and earnings to be increasing faster than the share price. How will we attempt such a screen?
- EPS must be over 0.20.
- Market growth will be much slower than book value growth.
- PE ratio will be below its 5-year average.
- EPS growth for the year will be positive.
- 3-month price appreciation will be positive.
Stocks Growing in Price Slower Than Fundamentals
Bunge Ltd. (NYSE:BG): This is a large agricultural and food business which is into oilseeds, grains, sugars, and corn. A quick look at 5-year growth rates shows BG to have higher growth than its industry group. Sales growth is 75% higher, and net income growth is roughly triple the 5-year industry average. Note that the 10-year average price to book ratio is 1.37, while the current ratio is 0.92. Since 2007, this ratio has fallen (despite a recent little jump up) in the face of a decade-high net profit margin, 9-year trend of declining debt/equity ratio, and a 9-year high on the return on equity ratio. The trailing PE is under 5, although the forward PE is more than double that.
Still, does this stock deserve to have higher valuations when looking at historical averages? A nice breakout past the $425 range gives support to this potentially undervalued stock.
International Speedway (NASDAQ:ISCA) is a corporation looking after Nascar racetracks. The 17.5% float short could really give this a lift, as prices have popped off a $25 support and look to break past $30 resistance. There is a big uphill mountain for these cars to climb.
Fundamentals show that earnings are only half of their historical averages, and prices have been swiftly punished. Still, earnings were up last year and we hope the trend continues. What of relative valuations? Price to book has dropped from the 2s and 3s over the last decade to 1.19 today. Price to sales around 4 was a reality six to 10 years ago, but now that number is only 1.77. Price to earnings are near norms if not slightly above at about 16, but the forward PE is only at 15.6, which is well below average. Possibly the most disturbing is how the net profit margin is only half of what it used to be at 8.45%.
With a steady increase in book value over the past decade, this stock with decent valuations would do well to increase its margins to keep the recent momentum up.
Other Potential Undervalued Picks
Other stocks with a short- or long-term trend of declining price to book value are as follows:
When trying to analyze stocks that are potentially undervalued, keep a close eye on expected future EPS growth, revenues, and changes in net profit margins. A stock might be undervalued and popping, but if future growth prospects are grim, despite a gradual increase in book value, you could be holding a very long time without substantial price appreciation.
Do you try to pick undervalued stocks? I’d like to hear your comments on these stocks.