How to Find Undervalued Stocks

By Markets Fool.com

Image source: Getty Images.

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Buying solid companies at conveniently low valuation levels can be a powerful strategy to maximize investment returns over the long term. With this in mind, let's take a look at a simple and effective screen to hunt for undervalued stocks, and why names like Apple (NASDAQ: AAPL), IBM (NYSE: IBM), and Foot Locker (NYSE: FL)come out as interesting candidates to consider.

By the numbers

To begin with, let's look for companies trading at a forward price to earnings ratio below 15. As a reference, the average company in the S&P 500 index carries a forward price to earnings around 19.3, so stocks that pass this screen are trading at a significant discount versus the broad market.

It doesn't make much sense to simply buy a stock because it looks cheap, we also need to consider variables such as business profitability in order to avoid companies that are generating insufficient returns for shareholders. Return on equity-- ROE -- tells us how much profit a company generates for every dollar of shareholder capital, and ROE ratios above 20% are generally considered attractive. Only companies with a ROE ratio above 20% are included in the screen.

When a profitable company is trading at a discounted valuation, this is usually because there is some reason for negativity surrounding the business. In many cases, the outlook for sales and earnings is uncertain in the short term.

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In the following screen, we are only looking for companies with positive expectations for earnings growth over the next five years. The main idea is avoiding businesses which are on a permanent decline, focusing only on names which may be going through a challenging phase but still offer solid long-term prospects.

To wrap up, the screen looks for companies trading at relatively low valuation ratios, with healthy profitability levels, and with positive growth expectations in the coming years. Names like Apple, IBM, and Foot Locker are some of the companies that meet the specified criteria.

Company Fwd. PE ROE 5 Year Expected Growth
Apple 12.1 37.9% 7.85%
IBM 11.3 82% 2.85%
Foot Locker 12.6 21.5% 9.17%

Data source: FinViz.

Apple

Apple owns one of the most valuable brands in the world, and consumers are notoriously loyal to the company. However, Apple is reporting declining sales lately. Total revenue fell 15% year-over-year during the quarter ended in June. Interestingly, most of this weakness seems to be transitory as opposed to permanent, the iPhone 6 was a booming success for Apple in 2015, and this is making annual comparisons remarkably difficult in 2016.

But year-over-year comparisons will be less demanding in the coming years due to a more modest sales base in 2016, and iPhone renewal sales could be a strong driver for the company going forward. Besides, the services division looks particularly promising: The company produced $6 billion in sales from the services segment last quarter, with revenue increasing 19% year-over-year in this business.

When considering both potential for improvement in the iPhone segment and growing contribution from the services division, it doesn't sound unreasonable to expect improving financial performance from Apple in the middle term. If this happens, the stock could offer substantial upside room from currently depressed valuation levels.

IBM

IBM is going through a transition, the company is reducing exposure to hardware and other low-margin businesses, and this is hurting the company's top line. In this context, Big Blue reported a 3% decline in revenue during the second quarter of 2016.

On the other hand, IBM is aggressively investing in a group of businesses it has identified as strategic imperatives, this includes cloud, analytics, security, social, and mobile technologies. Revenue from strategic imperatives grew 12% last quarter, and these businesses now account for 38% of company-level revenue on an annualized basis.

Chances are that strategic imperatives will continue outgrowing the rest of the business going forward, and they should account for a growing share of total revenue in the coming years. Under such a scenario, overall performance could substantially improve, which would be a major positive for investors in IBM.

Foot Locker

Foot Locker operates in a remarkably challenging environment, as brick-and-mortar retailers are facing daunting competitive pressure from online operators. This is not only hurting revenue growth for traditional retailers across the board, but profit margins are also under heavy pressure because online competition is affecting pricing power. This is arguably one of the main reasons why Foot Locker stock is trading at a discount versus companies in other sectors.

But Foot Locker is successfully sailing through the storm, total revenue grew 5% last quarter, while comparable-store sales increased 4.7%. Importantly, gross profit margin increased from 32.6% of sales to 33% of revenue, so Foot Locker is proving that it has what it takes to continue delivering growing sales and earnings in the face of difficult market conditions.

Even a mediocre business can do well when conditions are favorable, but Foot Locker is delivering solid performance in a challenging environment, and this reflects well on the company's fundamentals and its management team quality.

The Foolish bottom line

There is no infallible formula to find undervalued stocks, but looking for cheap companies with strong profitability and healthy long-term prospects sounds like a good start. Apple, IBM, and Foot Locker are remarkably different businesses with their own weaknesses and strengths, but they have an important characteristic in common: The three companies look like attractive candidates for investors hunting for undervalued opportunities.

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Andrs Cardenal owns shares of Apple and IBM. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.