What Makes a Stock Undervalued?

At a high level, there are usually two schools of thought when it comes to investment strategy and philosophy. One method, which worked well up until 2022 rattled the market, is focusing on businesses that are growing at a rapid pace. The other, popularized by legendary capital allocator Warren Buffett, is to seek companies that are selling at attractive valuations.

That latter style of investing might be more compelling right now given that many stocks are trading at prices well off their highs. To do it successfully, though, requires a bit of critical thinking on the part of investors. But what makes a stock undervalued? There are some key attributes to look for to figure out the answer.

Trader thinking and looking at charts on monitors.

Image source: Getty Images.

Going through temporary problems

Before focusing purely on analyzing valuation, let's turn our attention to something more qualitative in nature. A business is believed to be undervalued if its stock price is trading for less than one estimates its true worth to be, otherwise known as its intrinsic value. And this type of situation can happen when investors sour on a particular stock. This prompts the question: Why wouldn't investors want to own a specific company?

With this framework in mind, a good place to find undervalued stocks is to look for great businesses that are going through temporary problems. Negative headlines might cause short-term investors to shun certain stocks, even though the long-term outlook still remains intact. This is where your attention should be to find good buying opportunities.

We can look at a couple of big tech stocks to help illustrate this point. Consider Alphabet, a dominant internet company that has a monopoly on the search market via Google Search, the world's most prominent mobile operating system in Android, an incredibly popular streaming video service in YouTube, and a budding cloud computing offering. But because Alphabet is so dependent on the digital advertising market, which can be cyclical, it faced a slowdown in 2022. And its stock has fallen 31% from its peak.

Or consider Amazon. The e-commerce juggernaut also owns the leading cloud computing platform in AWS, has a rapidly expanding digital ad segment, and has its hands in the streaming entertainment industry with Prime Video. All of these areas have sizable growth potential, despite Amazon's customer base of consumers and enterprises trying to pare back spending recently. As of this writing, shares are off 45% from their all-time high.

It's hard to imagine a scenario where both Alphabet and Amazon don't continue thriving once the economic picture improves. Again, these are great businesses dealing with temporary issues. And as such, their stocks appear to be undervalued

Running the numbers

Now that we've figured out reasons for why a company might be undervalued, as well as a good hunting ground for where to find these types of opportunities, let's discuss the quantitative factors that are involved.

From a purely analytical perspective, stocks can be undervalued because they are trading at attractive valuation multiples. Now, this can mean that they are cheap relative to their own histories, relative to peers, or relative to the overall market. And the metric to use, whether it's enterprise value-to-EBITDA, price-to-sales, or price-to-earnings (P/E) ratio, depends on the specific company being considered. If a business doesn't earn positive net income, then you obviously wouldn't be able to use the P/E ratio.

For our purposes here, consider Home Depot. The top home-improvement chain currently trades at a P/E ratio of under 18, which is substantially below its trailing five-year average valuation. What's more, Home Depot sells at a discount to Lowe's, its smaller rival that trades at a P/E multiple of 20.6. And if that isn't enough to prove that this is an undervalued stock, as of this writing, Home Depot's P/E ratio is even slightly below that of the S&P 500, which trades at a multiple of 18.6.

Of course, the company in question must still have a bright outlook. Home Depot has leading market share in a massive, fragmented industry, usually reports better margins than Lowe's, and is essentially a mission-critical supplier for its customer base. This bodes well for its future.

Now that investors are well versed in what specific factors to look for when determining whether a stock is undervalued, it's time to apply this to your own portfolio.

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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Neil Patel has positions in Alphabet and Amazon.com. The Motley Fool has positions in and recommends Alphabet, Amazon.com, and Home Depot. The Motley Fool recommends Lowe's Companies. The Motley Fool has a disclosure policy.