The summer's hike in the U.S. stock market was just temporary; according to the Morningstar US Market Index, stocks were down more than 4% during Q3 as we saw persistently high inflation, rising interest rates, and rumors of an economic downturn. The S&P 500 was up 5.38% in November, bringing its YTD return to -14.39%, and the Dow Jones Industrial Average gained 5.67% for the month and was down 4.81% YTD as earnings came better than expected than market consensus with a 69% beat rate accounting for 191 of the 276 reported firms exceeding expectations. As well as, the hopes of the Fed slowing down the pace of interest rate hikes.
Stocks valuation is not an easy task as it requires fundamentally analyzing the stocks from all aspects including industry analysis, and horizontal and vertical financial analysis including evaluating the company’s management, future growth rates, and risk factors. To determine the fair value of a stock which is the estimated price agreed upon by buyers and sellers, there are several ways. One of the most widely known strategies is using the Discounted Cash Flow, Fair Value= Total value of its future free cash flows (FCF) discounted back to today's prices. Another widely known strategy is using Peter Lynch’s Fair Value calculation which is based on the company’s earnings and growth rate. Peter Lynch believes that “Fair Value=EPS*EPS Growth Rate” with a limited growth rate for companies of 0-40% to have a more accurate comparison. For example, A company's fair valuation is 30 times its earnings if its earnings increase 30% annually. Similarly, a business with annual earnings growth of 5% should have a PE of 5. If a stock is trading at a level higher than the calculated fair value, he says it is overvalued and vice versa. Another simple indicator of a stock’s value is its Price to Earnings ratio (P/E). For example, if a company’s P/E is 4; it means that for every dollar of profit earned by the company, the shares are being sold at 4 dollars.
Heading into the fourth quarter, stocks seem to be undervalued; the median stock in Morningstar’s North American coverage traded at more than a 20% discount to their fair value estimate. According to Morningstar, small-value companies are the most undervalued investment strategy, selling 47% below their estimate of fair value, while large-cap core stocks are only slightly undervalued (13%). The two most undervalued industries by sector are consumer cyclical and communication services, which trade at 43% and 25%, respectively, below their fair values. Meanwhile, the prices of defensive equities in the utilities, healthcare, and consumer sectors are almost fair-valued. Wide-moat equities, those with the strongest competitive advantage, are undervalued by a higher percentage (27%) than either narrow-moat that have some competitive advantage or no-moat stocks that have no sustainable competitive advantage.
Let’s see some undervalued stocks based on both approaches, Morningstar, for instance, calculates the long-term fair value estimate of a company based on how much cash is thought to be generated in the future. When determining the fair value estimate, Morningstar also considers the predictability of a company's future cash flows--the uncertainty rating. A stock with a higher uncertainty rating requires a larger margin of safety before earning a 4- or 5-star rating.
As we can see from the table above, even though according to the P/B and P/E ratios most of the stocks are overvalued compared to the book value per share or compared to their trailing price-to-earnings ratio, the other two strategies saw them as undervalued. Therefore, it is important for investors to understand the valuation criteria and match it with their investment strategies and needs.
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