Stock investing has always seemed technical, too technical for people who do not understand accounting and finance. This is because much of the talk around investing has often revolved around an investor’s ability to gather and digest ginormous amounts of financial information.

But in the real sense, investing is just about strategy and the approaches used to find great stocks. You could research mispriced stocks or stocks whose underlying business has great long-term strength. In this article, we shall focus on mispriced stocks, particularly how to identify and trade them.

Understanding mispricing

Behavioral economists argue that capital markets are not perfect because many investors make irrational decisions. The imperfect nature of the markets is manifested in the divergence between a financial asset’s prevailing price and the asset’s underlying value.

Let us consider this illustration: Mathew is interested in the stock of a tech company. He can see that the company’s stock market price is $50, but he cannot tell where it will go from here, so he enlists John’s services. John is a professional financial analyst who sometimes works on freelance gigs. 

John does evaluate the present discounted value of all cash flows that the tech company generates. Later in the day, John meets up with Mathew and asks him to buy as much of the tech company’s stock as possible because the shares are undervalued. What just happened?

Mispricing of an asset refers to when the prevailing market price diverges from the asset’s fundamental value, often called undervaluation or overvaluation. Certain economic events lead to asset mispricing, which also reflects the imperfect nature of capital markets. In Mathew’s case, the tech company’s undervaluation implies that the probability of the price rising in the future is beyond a reasonable doubt.

How do you identify mispriced stocks?

Before we dive into how to identify mispriced stocks, wouldn’t you want to know why the market mispriced assets? At any given point in time, investors are always looking for the best stocks to buy. But the stock investing space is competitive, yet few investors have the knowledge, skills, and time to perform advanced market analyses. As such, group mentality holds a significant sway on the investors.

Group mentality means that most of the market chases a few popular stocks while leaving a big chunk of stocks unattended. It means there will be industries the market will be looking at more than others, and some stocks might never meet investors’ eyes for years, which often leads to them being hugely underpriced. How, then, do you stand out and spot these mispriced stocks?

Determine a stock’s intrinsic value

Intrinsic value refers to the company’s value behind a stock, and it is determined using fundamental analysis. The difference between intrinsic value and the stock’s prevailing market price is that the latter is subject to market whims. Contrariwise, the intrinsic value is the true valuation because it relies on hard fundamental data.

But this means you will have to go around the market calculating the true value of stocks, right? Right. The good thing is that calculating a stock’s intrinsic value is easy, and we will show you how to do it.

Three different approaches exist on how you can determine a stock’s intrinsic value. In this illustration, we shall be using the easiest method that has proven to yield reliable results (although it might not be the best approach available). We shall calculate the true value using financial metrics that all public companies report in their quarterly financial statements.

Consider JLX, a fictional company that manufactures electronic components for the music industry. Over the past year, the company reported earnings per share of $4.25. After a little investigation, you determine that JLX can grow its earnings by about 13.0% for the coming four years. According to the latest financial report, JLX’s P/E ratio stands at 40.1. You are supposed to calculate JLX’s intrinsic value.

You can use the financial metrics given to calculate JLX’s intrinsic value in a few simple steps. First, you need a formula which is: 

Intrinsic Value formula

where r is the expected earnings growth rate.

Intrinsic Value

From the computation, the market has grossly mispriced JLX because its true value is $192.58 per share.

Comparable analysis

A company’s fundamental data is worthless if it is considered in isolation. For example, JLX’s real per-share value could be $192.58, but this figure might not be as breathtaking compared to the intrinsic per-share earnings of other companies. The good thing about comparable analysis is that you might never need to calculate the true value of each company you wish to investigate. All you have to do is obtain financial ratios such as the P/E ratio for each company and make the comparison. 

Illustration: Company X’s current P/E ratio is 20 while Company Y’s is 15. Both companies operate in the same sector, and their fundamental data is almost identical. In this case, the market falsely believes Company Y is less valuable than Company X, and it has it grossly undervalued.

Use precedent transaction analysis approach

Precedent transaction analysis determines a company’s implied market value. It entails using past M&A deals to see what it would cost to acquire a similar business at the time. Let us see an illustration.

The first step involves searching for past M&A data in the industry. Let us assume that the table below shows the top five M&A deals you managed to glean from your research.

TransactionValuation
Date Target CompanyValue in $MBuyer EV/EBITEV/EBITDAEV/Sales
15/12/2020ABC Co.2,205JMW Ltd.21.5x10.3x1.5x
01/03/2020Swan Group8,500Big Pin Group10.4x6.2x0.9x
25/08/2019PLM Ltd.320Tondo Plc.12.9x9.5x2.1x
12/07/2017Sink Ent.145BLY Corp.21.8x17.8x1.2x
07/11/2017Great Plc.35,000P&O Group13.7x8.9x5.5x
Average valuation16.1x10.6x2.2x
Median valuation 13.7x9.5x1.5x

The next step involves analyzing the transactions, which will output valuation multiples such as the average and median valuation multiples. Lastly, apply the valuations to the company of choice. According to your preference, you could say that the 6x EV/EBITDA multiple is the low threshold, and 0x EV/EBITDA multiple is the high threshold. You could also say the valuation range of $200 million to $5 billion is the low and high valuation threshold, respectively.

This process is a more involving yet less complicated method of assigning theoretical value to a given company. The results provide you with the firm ground to stand on as you make investment decisions.