Many investors concentrate on those stocks that are often in news and that are followed by the masses. They feel most comfortable with these familiar names. This practice is foolish. Such stocks are less likely to be undervalued.
It is not entirely proper to fault investors for this general approach, as they cannot analyze thousands of companies. We all need simple ways to whittle a huge number of options down to a manageable few.
However, there are more effective and profitable ways of doing this whittling. Here, we present some simple but effective steps that will help the average investor to zero in on the undervalued stocks to invest in now.
Before we begin, we would like to remind you of the words of Warren Buffets, “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Decide on the Quantifiable Criteria to Identify the Best Investment Options-
In the first stage of the analysis, the investor cannot devote much time to each and every stock. Investors cannot do much “thinking” about the stocks that are potential investments. In other words, investors must use quantifiable and unambiguous criteria that will objectively and reliably lead them to potential investments that will beat the averages in terms of risk-adjusted return (if only in a slight way).
Candidates for consideration include the return on equity ratio, the debt to equity ratio, the current ratio and other financial ratios. Currently, most shrewd investors would say that expected return on equity should be above 10%, debt to equity must be less than 0.5, and current ratio must be above 2. But, understand that these exact numbers vary over time. In certain markets and under certain conditions, these cutoffs may change dramatically.
Apply these objective criteria to actual investments to identify stocks with the greatest potential. Come up with a shortlist of stocks on which you can focus much more time and energy.
Although at this point all you are doing is crunching numbers, apply your objective criteria carefully, critically and thoughtfully.
Calculate the Intrinsic Value–
Determine the intrinsic value of these high-potential stocks. Determining intrinsic value is a much more time-consuming task; and at times, it is a much more subjective task. It requires you to make an assessment about such hard-to-quantify but important characteristics as shareholder friendly culture, sustainable competitive advantage, and honest management.