Bargain stocks aren’t just penny stocks; they can be high-quality value stocks, too

Hunting for bargain stocks doesn’t always mean penny stocks. Many investors seek out “value stocks” (or stocks that are reasonably priced, if not cheap, in relation to their sales, earnings or assets).

One of the sweetest and most profitable pleasures of successful investing is to buy high-quality “value stocks” and then hold on to them as mainstream investors recognize the value and push up the share price.

Characteristics of bargain stocks

Bargain stocks will trade lower than their financial fundamentals suggest. They are perceived as undervalued, and have the potential to rise.

Some investors look only for companies that fall into the undervalued category. These investors are less likely to invest in a growth stock because they feel that a value stock will eventually reach its full potential once it is recognized by the market.

Generally speaking, the climb is steadier for value stocks. The exception is if it transforms into a growth stock, perhaps by being more aggressive and innovative with its products or services.

Four financial ratios we use to uncover bargain stocks/undervalued stock picks

When you’re looking for undervalued stock picks, as a first step it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele.

High-quality bargain stocks like these are rare and hard to find, even when the markets are down. But when you know what to look for, you can discover them. These are four of the financial ratios we use as a guide to spotting them:

1. 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.

We calculate each p/e ratio 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.

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.

2. 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 instant 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.

When we find a stock with a low price-to-book value, we look to see if the price is too low, or if its book value per share is inflated. Often, we find that the stock price is too low. But, sometimes, the company’s assets are overpriced on the balance sheet, and at risk of being written down.

3. 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. We also like to look at debt to market cap.

4. 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.

Do you seek bargain stocks frequently? How often have you found some that turned into high-quality value stocks? Share your experience with us in the comments.