Investing 101: 7 Undervalued Stocks With Improving Profit Margins

If you're on the hunt for undervalued companies with encouraging accounting information, the following may be a good starting point for your search.

We started with a universe of companies that have reported rising gross margins year over year for the past three years. Gross Margin is the percentage of profits a company makes for each dollar generated in sales after paying all production expenses. Costs include overhead, payroll, and taxation.

Gross Margin = Gross Profit / Revenue

The higher the percentage, the greater the gross profits taken from revenue. A rising gross margin often indicates a company is better able to control its costs.

The Graham Equation
Next we searched for companies that appear undervalued when applying the Graham Number. The Graham number is a value equation created by the "godfather of value investing," Benjamin Graham. The equation calculates the maximum fair value for any stock, and it's based on only two data points: current earnings per share and current book value per share.

The Graham Number = Square Root of (22.5) x (TTM Earnings per Share) x (MRQ Book Value per Share)

This equation assumes that a stock is overvalued if P/E is over 15 or P/BV is over 1.5. Therefore, stocks trading significantly below their Graham Number are "undervalued" according to the equation.

The list
Combining these ideas, the following list of companies have reported rising gross margins and are undervalued according to the Graham equation.

Rising gross margin implies the company has become more profitable, but these names are still trading at a discount to fair value. Do you think they will rise in value? (Click here to access free, interactive tools to analyze these ideas.)

1. Calamos Asset Management: Provides investment advisory services to individuals including high net worth individuals, and institutions. Gross profit margins increased from 77.12% to 77.46% during the first time interval (12 months ending 2008-12-31 vs. 12 months ending 2007-12-31). For the second time interval, gross margins increased from 77.46% to 77.99% (12 months ending 2009-12-31 vs. 12 months ending 2008-12-31). And for the final time interval, gross margins increased from 77.99% to 78.69% (12 months ending 2010-12-31 vs. 12 months ending 2009-12-31). Diluted TTM earnings per share at 1.06, and a MRQ book value per share value at 9.32, implies a Graham Number fair value = sqrt(22.5*1.06*9.32) = $14.91. Based on the stock's price at $11.77, this implies a potential upside of 26.67% from current levels.

2. Solar Capital (Nasdaq: SLRC  ) : A business development company specializing in investments in leveraged companies, including middle market companies. Gross profit margins increased from 74.88% to 81.86% during the first time interval (12 months ending 2008-12-31 vs. 10 months ending 2007-12-31). For the second time interval, gross margins increased from 81.86% to 84.74% (12 months ending 2009-12-31 vs. 12 months ending 2008-12-31). And for the final time interval, gross margins increased from 84.74% to 85.32% (12 months ending 2010-12-31 vs. 12 months ending 2009-12-31). Diluted TTM earnings per share at 1.44, and a MRQ book value per share value at 21.2, implies a Graham Number fair value = sqrt(22.5*1.44*21.2) = $26.21. Based on the stock's price at $22.19, this implies a potential upside of 18.11% from current levels.

3. Level 3 Communications (Nasdaq: LVLT  ) : Engages in the communications business in North America and Europe. Gross profit margins increased from 57.06% to 57.94% during the first time interval (12 months ending 2008-12-31 vs. 12 months ending 2007-12-31). For the second time interval, gross margins increased from 57.94% to 58.4% (12 months ending 2009-12-31 vs. 12 months ending 2008-12-31). And for the final time interval, gross margins increased from 58.4% to 59.19% (12 months ending 2010-12-31 vs. 12 months ending 2009-12-31). Diluted TTM earnings per share at -5.67, and a MRQ book value per share value at -4.4, implies a Graham Number fair value = sqrt(22.5*-5.67*-4.4) = $23.69. Based on the stock's price at $17.64, this implies a potential upside of 34.31% from current levels.

4. Nanometrics: Provides high-performance process control metrology systems used primarily in the fabrication of semiconductors, high-brightness LEDs, data storage devices, and solar photovoltaics. Gross profit margins increased from 42.13% to 43.81% during the first time interval (52 weeks ending 2008-12-27 vs. 52 weeks ending 2007-12-29). For the second time interval, gross margins increased from 43.81% to 47.09% (53 weeks ending 2010-01-02 vs. 52 weeks ending 2008-12-27). And for the final time interval, gross margins increased from 47.09% to 54.37% (52 weeks ending 2011-01-01 vs. 53 weeks ending 2010-01-02). Diluted TTM earnings per share at 2.36, and a MRQ book value per share value at 8.99, implies a Graham Number fair value = sqrt(22.5*2.36*8.99) = $21.85. Based on the stock's price at $18.01, this implies a potential upside of 21.31% from current levels.

5. Medallion Financial (Nasdaq: TAXI  ) : Operates as a specialty finance company in the United States. Gross profit margins increased from 40.26% to 54.65% during the first time interval (12 months ending 2008-12-31 vs. 12 months ending 2007-12-31). For the second time interval, gross margins increased from 54.65% to 59.25% (12 months ending 2009-12-31 vs. 12 months ending 2008-12-31). And for the final time interval, gross margins increased from 59.25% to 60.86% (12 months ending 2010-12-31 vs. 12 months ending 2009-12-31). Diluted TTM earnings per share at 1.04, and a MRQ book value per share value at 9.59, implies a Graham Number fair value = sqrt(22.5*1.04*9.59) = $14.98. Based on the stock's price at $11.14, this implies a potential upside of 34.47% from current levels.

6. Molson Coors Brewing (NYSE: TAP  ) : Distributes beer brands. Gross profit margins increased from 40.19% to 40.5% during the first time interval (52 weeks ending 2008-12-28 vs. 52 weeks ending 2007-12-30). For the second time interval, gross margins increased from 40.5% to 43.05% (52 weeks ending 2009-12-26 vs. 52 weeks ending 2008-12-28). And for the final time interval, gross margins increased from 43.05% to 44.32% (52 weeks ending 2010-12-25 vs. 52 weeks ending 2009-12-26). Diluted TTM earnings per share at 3.26, and a MRQ book value per share value at 43.61, implies a Graham Number fair value = sqrt(22.5*3.26*43.61) = $56.56. Based on the stock's price at $43.77, this implies a potential upside of 29.22% from current levels.

7. KBR (NYSE: KBR  ) : Operates as an engineering, construction, and services company supporting the energy, hydrocarbon, government services, minerals, civil infrastructure, power, and industrial sectors worldwide. Gross profit margins increased from 4.77% to 5.81% during the first time interval (12 months ending 2008-12-31 vs. 12 months ending 2007-12-31). For the second time interval, gross margins increased from 5.81% to 5.88% (12 months ending 2009-12-31 vs. 12 months ending 2008-12-31). And for the final time interval, gross margins increased from 5.88% to 6.82% (12 months ending 2010-12-31 vs. 12 months ending 2009-12-31). Diluted TTM earnings per share at 3.06, and a MRQ book value per share value at 16.98, implies a Graham Number fair value = sqrt(22.5*3.06*16.98) = $34.19. Based on the stock's price at $28.6, this implies a potential upside of 19.55% from current levels.

Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.

Your browser does not support iframes.

List compiled by Eben Esterhuizen, CFA. Kapitall's Eben Esterhuizen and Rebecca Lipman do not own any of the shares mentioned above. EPS and BVPS data sourced from Yahoo! Finance, accounting data sourced from Google Finance.