Use these ratios, our tips on spinoffs, and other advice for long-term gains with top undervalued Canadian stocks. Learn more now.

Undervalued stocks are companies that typically have strong fundamentals and are trading, for one reason or another, at a low share price.

When you’re looking for cheap stocks—including top undervalued Canadian stocks—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.

How do I find top undervalued stocks in the Canadian market?

To find top undervalued stocks in the Canadian market, focus on companies with low price-to-earnings ratios, strong fundamentals, and solid growth potential relative to their current market value.

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 their share prices.

How do I differentiate between a genuinely undervalued stock and a value trap?

“Value trap” suggests that a stock looks cheap on a statistical basis, but is likely to get much cheaper. It may have an unusually high dividend yield, an unusually low p/e (the per-share price-to-earnings ratio), a low ratio of stock price to book value, or any of several other conventional signs of per-share value.

Any of these indicators can make a stock look like a bargain. But a value-trap stock may be cheap compared to past historical statistics because its stock price has plunged due to heavy selling by insiders or well-informed investors who recognize it has a dismal long-term future.

To avoid value traps, look for consistent cash flow growth, expanding profit margins, and positive earnings surprises alongside the low valuation metrics to distinguish genuinely undervalued stocks from value traps.

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.

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What financial ratios indicate a good undervalued stock vs. a value trap?

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.

What is a manageable level of debt for an undervalued stock?

A manageable debt-to-equity ratio for an undervalued Canadian stock typically falls below 0.5, though this varies by industry with higher ratios being acceptable in capital-intensive sectors like utilities.

What is a healthy current ratio, indicating the company can meet its short-term obligations?

A healthy current ratio for an undervalued Canadian stock is typically 1.5 or higher, indicating the company has enough short-term assets to cover its short-term liabilities.

Finding the top undervalued Canadian stocks for long-term gains

TSX value stocks are companies that are undervalued, based on a number of measures, on the Toronto Stock Exchange.

Some investors only feel safe buying stocks after prices have risen, which means that they often overlook TSX value stocks. Yet this is the opposite of the way you make most purchases (cars, clothing, etc.) Ordinarily, it’s better to buy when prices go down, not up. When buying stocks, you’ll find this same logic applies.

The first step to finding TSX value stocks is to visit the websites of the companies you are interested in investing in. Get on their mailing lists, and read their quarterly and annual reports. Ask your broker for research reports. Read the business news every day. You’ll be less liable to get caught off guard by price fluctuations and over time you’ll begin to spot the most undervalued stocks in a lineup simply through observation.

In addition to getting to know the companies you invest in, you should also get to know the industries that stocks operate in. Some industries are more volatile than others. Don’t invest in industries you’re not familiar with, and you’ll steer clear of many overvalued stocks.

Consider earnings, dividends and other factors in making decisions. They matter far more than short-term stock-price trends.

Stock prices rise and fall. But strong stocks tend to fall less and rise faster than poor stocks. And don’t overlook top dividend stocks—these companies like to ratchet their dividends upward. Even during market downturns, the last thing a well-established company is likely to do is lower its dividend. When times are good, strong companies will raise their dividends.

Some of the best undervalued Canadian stocks have hidden assets

Typically, when you find hidden assets, you are well on your way to finding good value stocks. Indeed, some of the value stocks that have done best for our subscribers are well-established stocks that unlocked the hidden value in their real estate holdings, their brand names, their research and development, or other assets that were not on their balance sheets at full value.

This is also why we pay special attention to holding-company discounts and spinoffs that reward investors by bringing hidden assets to the fore.

All in all, the deeper the value a stock offers, the greater the potential for profit.

Meanwhile. our search for value begins with our three-part Successful Investor philosophy (see below). 

Top undervalued Canadian stocks can include spinoffs

When a spinoff begins trading, it stands to reason that investors will put a low price on it. After all, the spinoff hits the market with a large number of neutral, if not reluctant, stockholders who have limited expectations for it, and who are willing to sell when they get around to it.

One group of investors who might be willing to buy a new spinoff are value seekers. And on the whole, it pays to follow the lead of these seekers of undervalued stocks, and to hang on through a period of sluggish trading that can occur when reluctant spinoff holders exercise their urge to sell.

What are the risks and benefits of investing in undervalued Canadian stocks?

Benefits: potential for higher returns when stocks rebound to fair value; risks: value traps where cheap stocks remain undervalued indefinitely, market volatility affecting shorter-term performance, and company-specific issues that caused the initial undervaluation.

Use our three-part Successful Investor approach to find top undervalued Canadian stocks 

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. 

Some investors believe value investing is dead. Do you agree or disagree?

What do you feel are the keys to finding undervalued stocks?

This post was originally published in November 2021 and is regularly updated.