When looking to spot undervalued stocks, look at factors like hidden assets, financial ratios, and growth prospects. Read on to find out more about this process

Undervalued stocks are companies that have strong fundamentals and are trading, for one reason or another, at a low share price. When you’re looking for undervalued stock picks, 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. Undervalued stocks like these are hard to find, even when the markets are down. But when you know what to look for, you can discover them.

Knowing how to find undervalued stocks is very similar to finding hidden value or assets in a company. This hidden value could take the form of real estate, research spending or loyal customers.

As well, companies often do spinoffs or create new companies from internal divisions or departments when they feel it isn’t a good time to sell them outright. Instead, they choose to hand out shares of the new firm to their shareholders. That often results in undervalued stock buying opportunities.

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Here are some tips on finding undervalued stocks for your portfolio 

Market pessimism can let you find some undervalued gems—stocks that drop along with the market as a whole yet still have sound fundamentals. But one of the sweetest and most profitable pleasures of successful investing is to buy high-quality “value stocks” (or stocks that are reasonably priced, if not cheap, in relation to their sales, earnings or assets), then hold on to them as investors recognize the value and push up the share price.

Value stocks are typically stocks trading lower than their financial fundamentals suggest. They are perceived as undervalued, and have the potential to rise. Many new tech stocks, for instance, start out as growth stocks and transition into value stocks.

When they look for value stocks to buy, investors usually start by looking at a few basic ratios. For example:

• Low price-to-earnings ratio—a sign of a cheap or undervalued investment.
• Low price-to-book-value ratio—another sign that a stock is cheap in relation to other stocks on the market.
• High dividend yield—the stock’s annual dividend divided by the share price. A high dividend yield could indicate a cheap stock that is set to rise.

These financial and growth factors are great indicators of undervalued stocks

• 5 to 10 year history of profit. Companies that make money regularly are safer than chronic or even occasional money losers.
• 5 to 10 years of dividends. Companies can fake earnings, but dividends are cash outlays. If you only buy dividend-paying value stock picks, you’ll avoid most frauds.
• Manageable debt. When bad times hit, debt-heavy companies often go broke first.
• Freedom from business cycles. Demand periodically dries up in “cyclical” businesses, such as resources and manufacturing. That’s why you need to diversify. Invest in utility, finance and consumer stocks, along with cyclical resource firms and manufacturers.
• Ability to profit from secular trends. For undervalued stock picks, among others, these trends outlast ordinary business booms and busts, because they reflect ongoing social change. Rising environmentalism and socially conscious investing are just two examples of secular trends.
• Ownership of strong brand names and an impeccable reputation. Customers keep coming back to these businesses, and will try their new products.
• Spinoffs are often undervalued stocks in disguise. Companies often do spinoffs when they feel it isn’t a good time to sell. Instead, they choose to hand out shares of the new firm to their shareholders. That often results in buying opportunities in undervalued stocks. 

How to find undervalued stocks: Look for hidden assets  

For a long time, we’ve written about the “heads-you-win-tails-you-break-even” phenomenon. That’s what you get in an investment that exposes investors to limited risk of long-term loss, but one that can deliver healthy if not substantial returns.

These situations sometimes come about when a stock has been an unimpressive or weak performer for a number of years. When that happens, investors often focus on the earnings weakness and lose sight of the company’s assets.

If you buy a stock for its hidden assets, but those assets stay hidden or ignored by investors—or turn out to be less valuable than you thought—it can’t hurt your investment. By definition, a stock’s hidden assets have not had much impact on its price. If you paid little if anything for the assets, you have little to lose. But the best hidden assets will eventually expand a company’s profit, grab investor attention, and push up its stock price.

Use our three-part Successful Investor approach in learning how to find undervalued stocks  

1. Invest mainly in well-established, dividend-paying companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources &Commodities; Consumer; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight. 

Undervalued stocks can be that way for a reason. How do you avoid investing in a problematic stock?

What factors do you consider in looking for undervalued stocks?