You often come across ideas from analysts suggesting several techniques to find value stocks. Though most of these ideas are feasible, they nevertheless call for long hours of due diligence. If you are looking for stocks that offer more "bang for the buck" but want to bypass such extensive research, here is a quick way out.
Simply look for the average target price provided by analysts on a particular stock and compare that with its current price. This will give you a good starting point to determine whether or not a stock is undervalued. This information, when combined with the Zacks Rank, has the potential to give you winning picks.
There are a number of valuation metrics/methods to find undervalued stocks, including price-to-earnings ratio, price-to-book ratio and implicit growth. But the majority of investors avoid finding out real undervalued stocks given the tall task involved.
Often the fear of wrong selection comes in the way of such research work. If you are apprehensive, depend on what the specialists say. Let the analysts use their knowledge to reach a target price, and you can simply follow them.
How to Do This?
Most of the analysts covering a particular stock set a target price, which they deem as its fair market value. They do it after their extensive evaluation on the fundamentals of the company. When a stock trades at a decent discount to the average of analysts’ price targets, you may consider it for purchase provided it meets another criterion.
Keep in mind, however, that a steep discount to the average target price is not always worth getting excited about. As there could be high target prices from extremely optimistic analysts, the average could be significantly inflated. Also, target prices for stocks with very small analyst coverage could be misleading as there are chances of over-representation from an optimistic view. So, following the most pessimistic target price for stocks with sufficient analyst coverage would be a safe bet.
Zacks Rank: A Confirmation
You should confirm your choice only after looking at the stock’s Zacks Rank. The Zacks Rank is a proprietary quantitative model that uses trends in earnings estimate revisions to classify stocks into five groups: Zacks #1 Rank = Strong Buy, Zacks #2 Rank = Buy, Zacks #3 Rank = Hold, Zacks #4 Rank = Sell and Zacks #5 Rank = Strong Sell. The earnings estimates in the Zacks Model come from brokerage or “sell-side” analysts.
Now, if you see that your target stock holds a Zacks #1 or #2 Rank, buying it could give you above-average returns.
(To learn more about the Zacks Rank, visit our Zacks Rank Education section.)
Four Undervalued Stocks
While there are several value stocks that you may add to your portfolio based on the above strategy, we believe the following four would be good additions:
Titan Machinery, Inc. : With a market capitalization of $451.7 million, it represents a diversified mix of agricultural, construction and consumer product dealerships located in the upper Midwest . The lowest among the target prices provided by 5 analysts stands at $29.00. The stock is currently trading at $22.47 (closing price on January 6, 2012), implying a discount of 22.5% from the most pessimistic target price. Also, the company currently retains a Zacks #1 Rank.
Stone Energy Corp. : With a market capitalization of $1.3 billion, it is independent oil and gas company headquartered in Lafayette, Louisiana, and is engaged in the acquisition, exploitation and operation of oil and gas properties located in the Gulf Coast Basin. The lowest among the target prices provided by 6 analysts stands at $34.00. The stock is currently trading at $26.83 (closing price on January 6, 2012), leading to a discount of 21.1% from the most pessimistic target price. This is also a Zacks #1 Rank company.
Denbury Resources Inc. : An oil and gas company engaged in the exploration, production and development of natural gas properties in the Gulf Coast region located in Mississippi, Texas, Louisiana and Alabama. The company has a market capitalization of $5.9 billion. The lowest among the target prices provided by 14 analysts stands at $20.00. The stock is currently trading at $17.27 (closing price on January 6, 2012). This implies a discount of 13.7% from the most pessimistic target price. The company currently retains a Zacks #2 Rank.
Washington Banking Co. (WBCO): Having a market capitalization of $182.9 million, it is a registered bank holding company whose wholly owned subsidiary, Whidbey Island Bank, a Washington state-chartered bank, conducts a full-service community commercial banking business. The lowest among the target prices provided by 8 analysts stands at $13.00. The stock is currently trading at $11.94 (closing price on January 6, 2012). This implies a discount of 8.2% from the most pessimistic target price. This is also a Zacks #2 Rank company.
The strategy to select stocks that trade at a significant discount to the most pessimistic target price is no doubt a smart and easy way to benefit from the stock market. But once you pick a stock based on this strategy, don't simply rest assured. Instead, continue to track all the developments on the company until you book your profit. Otherwise, you may see someday that your stock no longer carries a premium target price due to some major negative news on the company.
Keep a close watch on target price changes. Stay on guard if you see that the target price of a company is continuously falling… there must be something wrong.
Disclosure: The author has no positions in any stocks mentioned.