The path to spotting undervalued companies to invest in includes looking at select financial ratios as well as other key factors

There are two basic steps to finding undervalued companies to invest in: first, develop a rough list of stocks that meet your basic criteria and direct you to investigate further; second, do more in-depth analysis of these stocks by examining their financial data.

Once we’ve found a company that appears attractive on a value basis, we look to see if it is a solid operating business, with rising sales, earnings and cash flows in an expanding industry.

Use these financial ratios to spot undervalued companies to invest in for the highest long-term returns

Price-earnings ratios: The p/e is the ratio of a stock’s market price to its per-share earnings. As a general rule, the lower the p/e, the better, and generally a p/e of less than 10 represents excellent value.

To determine undervalued stock picks, we calculate the p/e ratio for a stock by using the most recent financial data. But we also analyze the “quality” of the earnings. For instance, we disregard a low p/e ratio if it is due to a one-time capital gain on the sale of assets, since the gain temporarily bloats the “e.” (That shrinks the p/e.) Similarly, we add back any one-time earnings writeoffs, so we don’t miss out on bargain stocks that would have had low p/e ratios if not for one-time writeoffs.

You need to remember that a low p/e can be a danger signal. A low share price in relation to earnings may mean earnings are falling or about to fall. That’s why it’s crucial to view p/e ratios in context. Instead, we check to see if other financial ratios confirm or contradict their value.

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Price-to-book-value ratios: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share gives you a rough idea of the stock’s asset value. This ratio represents a “snapshot” of an instance in time, and could change the next day. Asset values on a company’s books are the historical value of the assets when they were originally purchased, minus depreciation. (Certain types of assets on a balance sheet might have actual market values well above historical values, as sometimes happens with real estate or patents.)

Price-cash flow ratios: Cash flow is actually a better measure of a company’s performance than earnings. While reported earnings are subject to accounting interpretation and can be restated in later years, cash flow is a measure of the cash flowing into a company less cash outlays.

Simply put, it’s earnings without taking into account non-cash charges such as depreciation, depletion and the write-off of intangible assets over time. Cash flow is particularly useful in valuing companies in industries in which depreciation and depletion charges are based on the historical value of assets instead of current values. Those are industries such as oil and gas, and real estate. As with any financial ratio, you always have to look at it in context in order to find truly undervalued stock picks.

Debt to equity ratios: This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity. In essence, you assume an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of its capital.

Take a look at goodwill when analyzing undervalued companies to invest in

In analyzing a company’s financial statements, a key concern, and a potential pitfall for investors, is the amount of goodwill that it carries as an asset on its balance sheet. Goodwill is an accounting entry that reflects the price that the company paid for its acquisitions, minus the value of the tangible assets, like land and equipment, that it received as part of the acquisition. The term means “value as a going concern.”

In the right circumstances, goodwill can be extremely important to value stock picks, especially if it is “off-the-books” goodwill—that is, goodwill that a company developed through its own efforts, which does not appear on the balance sheet. Examples include the value of the company’s brand, or the reputation and relationship that it has built up with customers over the years.

On the other hand, if a big acquisition sours, a significant writedown of goodwill or intangibles could hurt the acquirer’s earnings and share price.

Use our three-part Successful Investor approach to help you find undervalued companies to invest in

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Would you invest in an undervalued stock that has a lot of controversy behind it?  

Do you think controversial but undervalued stocks can lead to favourable results?