On the surface, it seems so simple. Identify undervalued stocks, and make large returns. But what exactly makes a stock undervalued?
While there are certain ways to identify undervalued stocks, the fact is investors don't have a crystal ball telling them how the next five or ten years is going to play out. That's why it's important to research key metrics that could identify the potential for shares to rise.
Today, we're going to explore what makes a stock undervalued, and identify one that investors should consider adding to their watchlist this month.
What makes a stock undervalued
If investors are looking for undervalued stocks, the first key is to look at how a company has performed in the past. There are key metrics to narrow that focus a bit more, seeing whether a stock is trading below the historical norm.
Metrics
Three metrics to consider are the price-to-earnings (P/E) ratio, enterprise value (EV) in relation to earnings before interest and taxes (EBIT), and its price-to-sales (P/S) ratio.
As Tracey Ryniec explains, the P/E ratio is, “price of the stock divided by earnings. The cheaper it is, the better. Most value investors look for a P/E of 15 or less. A P/E o f 10 or less usually indicates a company is dirt cheap.”
The EV/EBIT ratio digs in a bit deeper, comparing the company's market capitalization and net debt in relation to its EBIT. This looks more at the company's overall value and how profitable it's been. Again, a lower ratio compared to historical levels and its peers could mean the stock is undervalued as well, as investors are paying less for each unit of profit.
As for the P/S ratio, this focuses on the company's stock price relative to its revenue per share. Investors can see how much other investors are willing to pay for every dollar of sales, with again a lower ratio compared to historical and peer averages perhaps indicating value.
Overall, if investors are paying less despite the company demonstrating a strong balance sheet, this could be a sign of value.
Who's buying
Fundamental analysis is a great place to start when identifying value, but you should also look at what company insiders are buying/selling. By looking at insider activity, investors can see whether company executives or board members are buying shares of their own company when shares fall. This is key, as insiders usually have non-public information. If they're buying shares, this could mean they are confident in the company's future prospects.
Renowned investors scooping up shares is another way to identify undervalued stocks. If finance gurus like Warren Buffett or Peter Lynch are buying the stock, retail investors should be watching closely.
Bank of America, an undervalued stock to buy in July
Shares of Bank of America (BAC) jumped by about 6% yesterday, as earnings came out that beat analyst estimates. Even after this rally, BAC is down 5% year to date (YTD), while WFC and JPM are up nearly 12% and 15%, respectively.
When it comes to fundamental analysis, BAC has a P/E ratio of 8.83, which is below its peers Wells Fargo (WFC) at 10.05 and JPMorgan Chase (JPM) at 10.12.
BAC's P/S ratio of 2.04 still makes it a healthy stock, though it is higher than its historical five-year average of 1.17. As for the EV/EBIT, it currently stands at 7.8, lower than its five-year average of 8.7.
These lower metrics can be directly related to the economic slow down, with lower earnings growth for most banks, including Bank of America stock until recently. Yet when earnings improve, Bank of America stock should have little difficulty turning around, given its strong balance sheet and profitable track record. This should lead to higher metrics in this case.
It certainly seems that insiders and smart investors think this will be the case. There has been a major shift in activity during the last few months that investors should pay attention to. In the last year, insiders sold about 2.2 million shares in total, according to insider activity, compared to 51,334 shares purchased.
However, in the last three months, there have been 103,909 shares sold, and 46,805 shares purchased. Given that 51,334 shares were purchased in the last year, this shows most of the activity in share purchases has been in just the last three months. This indicates that insiders might believe there is currently a strong reason to purchase the stock.
Meanwhile, according to its latest filing, Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) increased its investment on Bank of America stock. The Buffett-owned company lightly increased its stake to a total of 179.4 million shares. This was a 1.07% increase from the quarter before, with the company slowly but surely adding more of the stock to its portfolio, up 3.2% year-over-year.
Bottom line
With all this in mind, I believe BAC is an undervalued opportunity to consider. Bank of America insiders and Buffett are increasing their ownership positions recently and yet it still trades below historic fundamentals. What's more, shares may have increased on positive earnings, but are still down by about 5% in the last year. So if you're looking for value play and have a long-term investing horizon, Bank of America stock is a good candidate.
On the date of publication, Amy Legate-Wolfe did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
