How to Buy Undervalued Stocks

Jeremy Trevvett - January 15, 2021

Everybody knows the easiest way to make money in the stock market is to buy low and sell high… simple right? Not so much.

Too often people turn on the news or check social media, only to find that Tesla (TSLA) hit a new all-time high or Zoom (ZM) is up +400% on the year. And then they think, "Hey, maybe I should buy some and I can get rich too. It'll keep going up, right?"

There is a Time to Buy and a Time to Wait

Valuations are like civilizations: they rise and fall. A stock’s trading multiple fluctuates over time, depending on several factors, including company performance, broader economic conditions, and consumer sentiment, among others. Stocks with long trading histories develop patterns for valuation multiples that the market will tolerate.

The time to buy a stock is when its valuation is low relative to its trading history. Conversely, the time to sell is when its valuation becomes historically high.

Let's look at an example.

History of AMD

Advanced Micro Devices, Inc. (AMD) is a well-known semiconductor company whose stock price has outperformed the broader market throughout its history, though not without a few bumps in the road. Since the company went public in 1972 at $15.50 / share ($0.57 / share accounting for subsequent stock splits), AMD has generated a total return of +16,375%, compounding at an +11% CAGR.

AMD graph over the decades NASDAQ: AMD Stock Chart (Jan 1981 to Present). Source: Google Finance.

However, if you’d bought AMD at a time when the stock was trading above its fundamental value, your investment may have performed poorly. Let's take a closer look.

Early Stable Period

From its IPO until late 1996, AMD historically traded between 2.5x-4.5x EV/EBITDA. While the stock price performed very well during late 1996 / early 1997 (increasing +260% from its near-term trough in July 1996 to near-term peak in May 1997), it became quickly overvalued – reaching an EV/EBITDA of nearly 42x.

This overvaluation was recognizable to those who continually monitored AMD's trading multiples. However, those who chose to invest when the stock was historically overvalued may have lost a significant portion of their investment. AMD subsequently declined to its next trough within 14 months, shedding 64% of its value and returning to a ~12x EV/EBITDA valuation.

AMD EV/EBITBA table 1996-1998

Dot-Com Bubble Peak

At the height of the dot-com bubble, the stock again reached outlandishly high valuations – achieving an unprecedented 51x EV/EBITDA in April 2000. AMD investors at that time could have identified the stock as overvalued, recognizing the multiple expansion from 12x to 50x+. Selling at this point would have generated an enormous profit of +481%.

Conversely, those that invested during the mania of the stock's historic rise were subject to two outcomes, depending on how long they held the stock: (i) sell at a disappointing loss; or (ii) hamper long-term returns having not waited for a more appropriate entry valuation. Both outcomes are undesirable.

AMD EV/EBITBA table 1998-2002

2000s Stable Period

Because the fundamentals of the stock remained strong over the next few years, AMD's stock price recovered throughout the mid-2000s, all while trading within historically reasonable valuation ranges. AMD's EV/EBITDA did not again rise above 20x until July 2007, while the stock price increased from $3.76 at its prior trough in October 2002 to its next peak at $41.40 in January 2006. Note: AMD's financial performance deteriorated from 2006 to 2007, contributing to the significant decline in its stock price before the effects of the 2008 Financial Crisis.

Housing Bubble Peak

Heading into the 2008 Financial Crisis, the stock's valuation again soared to irrational levels – partly from depressed earnings and partly due to broader market exuberance. In November 2008, the stock traded at 31.5x EV/EBITDA.

AMD EV/EBITBA table 2002-2008

2010s Stable Period

For many years after the 2008 Financial Crisis, the stock hovered between $2 and $10. The company’s financial performance was rocky from 2012-2016. Meanwhile, the stock remained relatively cheap, trading between 4x and 15x EV/EBITDA. This valuation was far lower than the peaks of 42x in May 1997, 51x in April 2000, and 48x in June 2008. If you bought AMD at this level and held until today, you would have generated an astounding +864% return, compounding at a +23% CAGR.

Current Bubble Peak

AMD’s financial performance improved materially in recent years. The Company grew its top and bottom lines sequentially each year since 2016, contributing to the stock's incredible outperformance vs. the broader market since mid-2015.

During that period, however, its valuation multiples expanded significantly. Any guesses what AMD is trading at today? As of the date when this article was written (January 2021), AMD traded at an EV/EBITDA of 73x! Sound familiar? Let's see if history has taught us any lessons about the intrinsic value of this stock.

Disclaimers from the AMD Example

We are NOT saying that retail investors should have seen the dot-com or housing bubbles coming (though watching broad market valuations irrationally exceed historic levels certainly provided potential indicators). We detailed AMD’s trading history to demonstrate that retail investors can identify when a stock is potentially overvalued by looking at its trading multiples.

Valuations are not absolute predictors of stock price movements. Rather, they prove helpful as indicators for the intrinsic value of stocks over the long-term. If fundamentals improve, a company’s stock price should rise (as did AMD from 2016 to 2019). Conversely, when performance declines, the stock price should fall (as did AMD from 2006 to 2007). It is only when valuations become materially inflated that we begin to identify a stock as overvalued, having diverged from trading primarily on fundamentals.

Key Takeaways

If there is one thing you take away from this article, please let it be this: Despite AMD's record as a long-term outperforming stock, there were good times to buy and bad times to buy. In other words, there are times when the stock was undervalued, and times when it was overvalued.

A good investor's job, then, is to look past all the media hype to "get in while you can" and identify when a quality company's stock, like AMD, is truly undervalued. As the famous value investor Benjamin Graham once said, "You must never delude yourself into thinking that you're investing when you're speculating."

Five Tips to Generate Better Stock Returns

Easier said than done, right? Here are five crucial tips to follow when looking for great stocks to buy, so you can avoid paying too high a price and achieve better long-term investment returns.

1. Entry valuation is the #1 driver of long-term returns

There are times at which the stock is an attractive buy and times at which you should stay away. Appealing entry points are primarily driven by valuation.

This is certainly not a novel concept, but it is an important one that investors often neglect. Take a look at the following table which demonstrates the importance of valuation on returns. Relative to various entry points in AMD's stock history, returns are enhanced exponentially when the stock was relatively undervalued and severely hampered when relatively overvalued.

By avoiding stock purchases when they are historically overvalued, you substantially enhance your return on investment.

AMD EV/EBITDA all years

2. Cheap does NOT mean undervalued

Just because a stock is trading at a low valuation does not mean that it is a quality company. Many stocks on the market are incredibly cheap, not because of a temporary pullback from unjustified valuations, but because they are simply poor performing companies.

In the words of Warren Buffett, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

When looking for great stocks to buy, first make sure you have identified quality companies, then make sure you are paying a fair price.

3. Compare multiple valuation ratios

Investors utilize several ratios to characterize the valuation of any given stock. Among these are P/E, P/S, P/B, and EV/EBITDA (shown throughout this article). The problem with most of these ratios, however, is that none identify a stock as undervalued or overvalued. Instead, they rely on relative comparisons, either to prior points in the company's history or to industry peers. Furthermore, each valuation ratio tends to base its valuation only on one metric, which can often be misleading or provide meaningless comparisons between companies with different growth, profitability, and leverage profiles.

To combat this problem, we have developed a new, comprehensive valuation ratio powered by machine learning called the Fundamental Fitted Estimate Ratio ("FFER"). Each FFER is the ratio between a stock's actual price and its fundamental price. The fundamental price is the output of a machine learning model trained with 16 fundamental dimensions, including income, revenue, assets, liabilities, and dividends, among others.

Take a look at how the FFER stacks up relative to AMD's price performance throughout the past decade. Based solely on the fundamentals of the company, the machine learning model identified several attractive entry points when the stock was undervalued.

AMD vs FFER

4. Time is on your side

Once you know that the stock you are buying is a quality company and have identified a reasonable entry valuation, then the best thing you can do is wait.

The effect of compounding on long-term returns is remarkable. As noted above, with a stock like AMD (as well as countless other examples that weather several cycles), buying at an appropriate valuation and holding for the long-term consistently generate high returns.

This means you should not panic sell when the rest of the market does. If anything, you should increase your position when valuations become historically low (provided there are no material changes to the company's underlying fundamentals) and sell when they become historically high. This strategy mirrors another adage from the Oracle of Omaha: it is better to be "fearful when others are greedy, and greedy when others are fearful."

5. Utilize limit orders

Ever find a company you like but the stock is trading at a valuation above where you are comfortable buying in? Utilize a limit buy order to ensure you purchase the stock at a desirable valuation. A limit order lets investors set the number of shares to buy and the price at which to buy them. That way, if the price of that stock dips at or below your desired entry price, your order will place.

If the order cashes, then you bought a quality stock at a fair price. If it does not, then you potentially avoided paying too much for an overvalued stock. You may miss out on a few winners with this method, but that is okay! You will at least protect yourself from severe downside and refrain from buying stocks that are too expensive. Consequently, your overall returns will improve over the long-term.