Value investing, popularized by Benjamin Graham and Warren Buffett, focuses on buying stocks that trade below their intrinsic value. The goal is simple: find good companies at cheap prices and wait for the market to recognize their true worth. But distinguishing genuine value from value traps requires systematic screening. Here is how to find undervalued stocks.
What Makes a Stock Undervalued?
A stock is undervalued when its market price is less than its intrinsic value. This can happen for many reasons: the company is out of favor, the sector is unloved, there was a temporary setback, or the market simply overlooked it. Value investors profit when the market corrects this mispricing.
Value investing principle: Price is what you pay, value is what you get. A great company at a high price is not a good investment. A good company at a great price often is.
Essential Value Screening Criteria
Price-to-Earnings (P/E) Ratio
The most common valuation metric:
- Under 15: Traditional value territory
- Under 12: Deep value (may indicate problems)
- Compare to sector: P/E vs industry average
- Forward P/E: Based on next year's estimated earnings
Price-to-Book (P/B) Ratio
Compares stock price to book value per share:
- Under 1.5: Graham's original criterion
- Under 1.0: Trading below book value (often deep value)
- Best for: Financial companies, asset-heavy businesses
- Less useful for: Tech companies, service businesses
Benjamin Graham Value Screen
P/E ratio < 15
P/B ratio < 1.5
P/E x P/B < 22.5 (Graham's combined metric)
Current ratio > 2.0
Long-term debt < working capital
Positive earnings for past 10 years
This classic screen finds conservative, financially stable value stocks.
Additional Valuation Metrics
Price-to-Sales (P/S) Ratio
- Under 1.0: Strong value territory
- Under 0.5: Deep value
- Useful when: Earnings are temporarily depressed
- Compare to: Historical average and competitors
Price-to-Free Cash Flow
- Under 15: Good value
- Under 10: Strong value
- Better than P/E: Harder to manipulate than earnings
Enterprise Value to EBITDA
- Under 10: Reasonable value
- Under 6: Cheap
- Accounts for: Debt levels and cash on hand
Quality Filters for Value Stocks
Cheap stocks must also be quality companies:
Profitability Requirements
- Positive earnings: Profitable in most recent year
- Earnings consistency: Positive in 4 of last 5 years
- ROE above 10%: Generating returns on equity
- Positive free cash flow: Generating real cash
Financial Strength
- Current ratio > 1.5: Can meet short-term obligations
- Debt-to-equity < 1.0: Conservative balance sheet
- Interest coverage > 5x: Easily services debt
The Value Trap Problem
Not every cheap stock is a good investment. Value traps are stocks that appear cheap but deserve their low prices:
Warning Signs of Value Traps
- Declining revenue: Business is shrinking
- Falling margins: Competitive position weakening
- Industry disruption: Business model threatened
- High debt: Financial distress possible
- Insider selling: Management losing confidence
Avoiding Value Traps
Add these filters to your screen:
- Revenue growth > 0% (not declining)
- Operating margin stable or improving
- Positive analyst estimates for next year
- Some insider buying or at least no heavy selling
Margin of Safety
Graham's most important concept:
Margin of safety: Buy at a price sufficiently below estimated intrinsic value to allow for errors in analysis and unforeseen problems. The bigger the discount, the larger your margin of safety.
Practical application:
- If intrinsic value is $50, buy at $35 (30% margin)
- Higher quality companies need less margin (20%)
- Riskier companies need more margin (40%+)
Comprehensive Value Screen
A complete value stock screener:
- Market cap > $300 million
- P/E ratio < 15
- P/B ratio < 2.0
- P/S ratio < 1.5
- Dividend yield > 0% (pays dividends)
- Current ratio > 1.5
- Debt-to-equity < 0.8
- ROE > 8%
- 5-year revenue growth > 0%
- Positive earnings last 4 years
Sector-Specific Considerations
Financials
Use P/B ratio primarily. P/E less reliable due to loan loss provisions.
Cyclicals
Buy when P/E is high (earnings depressed at cycle bottom). Sell when P/E is low (peak earnings).
Utilities
Focus on dividend yield and regulatory environment. P/E less variable.
Technology
P/S and P/FCF more useful than P/B. Growth must justify higher multiples.
Patience is Essential
Value investing requires patience:
- The market may take years to recognize value
- You may be wrong - positions can stay cheap
- Diversify across 15-20 value stocks
- Have a thesis for why value will be recognized
Track Your Value Investments
Pro Trader Dashboard helps you monitor your value portfolio. Track your buy prices, current valuations, and returns over time.
Summary
Value screening uses metrics like P/E, P/B, and P/S to find stocks trading below intrinsic value. But cheap stocks must also be quality companies with solid fundamentals. Avoid value traps by requiring stable or growing revenue and avoiding companies with deteriorating competitive positions. Apply a margin of safety to account for uncertainty, and be patient - value investing rewards those who can wait for the market to recognize true worth.
Learn more: fundamental analysis basics and intrinsic value explained.