How to Find the Best Undervalued Stocks

August 14, 2012 at 16:42 PM EDT

Some of the world's most successful investors - from Sir John Templeton to Warren Buffett - made their reputations and fortunes by buying undervalued stocks and holding until the rest of the market recognized the stock's true worth.

Today, however, with the S&P 500 resting atop the 1,400 level and the Nasdaq just over 3,010, finding undervalued issues isn't as easy as it was a few months back.

Fortunately, there are tools that can help you more easily ferret out some of the market's remaining hidden gems and find the best undervalued stocks.

They're called "stock screeners." There are at least a half dozen free ones that you can access online to help you search for value among the more than 8,000 companies traded on the various U.S. stock exchanges and electronic networks.

Some are fairly basic, allowing you to analyze stocks based on just 10 or 12 different criteria, while a couple are quite comprehensive. They let you request data in up to 60 different fundamental, technical and descriptive categories.

Some allow you to enter a range of values - e.g., a price/earnings (P/E) ratio between 12 and 20. Others utilize an over/under format asking you to enter absolute numbers - e.g., a P/E "<18" (18 or less). All allow you to pick only the indicators you're interested in for a given screening.

However, before you can use any screener - and I'll provide links to several of the leading free ones in just a minute - you need to know which fundamental and technical measures are most useful in finding undervalued stocks poised to grow.

How to Find Undervalued Stocks Different analysts prefer different indicators - and you'll probably build your own list of favorites as you get more experienced - but almost everyone agrees on these:

Price/Earnings ratio - The P/E ratio is merely the stock's current price divided by the company's trailing 12-month earnings - and, since you're looking to buy value at a bargain price, a low P/E is a good place to start. As a rule, I like to see a P/E of 15 or less, but higher is acceptable in some sectors such as information and computer technology, health care and gaming.

Revenue growth - Today's undervalued stock might be tomorrow's overvalued issue if its revenue is stagnant. As such, look at a company's long-term revenue growth - i.e., its year-over-year numbers - as an indicator that it's capable of consistently increasing earnings in the years to come. Look for five-year average annual sales growth of 15% or more.

Net profit margin - A high net profit margin - the percentage of revenue going to the bottom line - indicates a company is operating efficiently and management is strong. A minimum of 10% is best.

Debt-to-equity ratio - A company will have more difficulty fueling revenue and earnings growth if it's spending a big chunk of cash servicing debt - and it could face added trouble if future sales drop and it can't meet those payments. Look for a ratio of 10% (0.1) or less.

Using a Stock Screener My favorite online screener is the one provided by FinViz.com - that's short for Financial Visualization. It's extremely easy to use, provides the most options for specifying the indicators you want, updates the list of search findings automatically each time you change a parameter and saves your screen once you devise one you like so you can use it again next week or next month, plus you can set it to display either a list of company names and symbols or charts of the stocks.

Using only the four fundamental indicators just described, FinViz gave me a list of 14 stocks priced at over $10 a share that met the valuation criteria.

Since that's a bit too many to work with, I added three more qualifiers:

Price-to-sales (P/S) ratio - This measures how much investors are paying for each dollar of a company's revenue, in a sense looking a level above the P/E ratio. Look for a ratio of 2.0 or less here.

Price-to-book (P/B) ratio - This measures the stock's price relative to the company's real assets, or book value. A low P/B ratio - say, less than 3.0 - can be a good indicator that a stock is undervalued, but only in combination with other solid financial numbers since it can also be a sign of internal troubles.

Dividend yield - I personally prefer stocks that pay at least a small dividend - designated by "positive" in the screener - because it demonstrates a commitment by the company to share earnings with stockholders. Other analysts like to see excess cash plowed back into the company to enhance growth, so this one is purely optional, depending on your own preferences.

You can also use some technical indicators to further narrow your search:

12-month relative strength (RSI): Undervalued stocks typically underperform the market, so if the RSI is strong, you've probably already missed the best buying opportunity. Though it's not that precise, I use a setting of "not overbought" when screening RSI.

Average trading volume - The same logic applies here as with relative strength - if a stock has a high daily volume, it's already been discovered by somebody, probably fund managers or institutions, and is most likely no longer truly undervalued. Still, you want adequate liquidity, so look for an average volume of 50,000 shares or more.

Adding these qualifiers cut the list to just two stocks - Spreadtrum Communications Inc. (Nasdaq: SPRD), a Chinese semiconductor firm trading as an ADR at about $17.45 a share, and True Religion Apparel Inc. (Nasdaq: TRLG), $21.70, a U.S. maker of high-end jeans and other casual wear that fell sharply in price a week or so ago after it lowered its revenue projections for the rest of the year.

I'm not recommending either company, but if you're interested in value, both could be worth a look.

You can also try FinViz.com using your own parameters.

And, if you don't like that one, try these other free online screeners: