What are Undervalued Stocks?
Cheap and undervalued are sometimes conflated, yet the two concepts are vastly different. When a stock’s price does not appropriately reflect the company’s prospects, assets, or revenue stream, it is considered undervalued. A bargain is not defined as a stock with a cheap share price.
They have a market price that is significantly lower than their fair value (market value < fair value) as a result of decreasing investor confidence or consensus estimates.
There’s a big difference between a stock that falls in value from being overvalued versus a stock that falls from fairly valued to undervalued.
Indicators To Determine Stock Value
Price alone cannot be used to determine if a stock is undervalued.
- Book Value- The use of book value is one approach to determine if a stock is undervalued. The total of all assets minus liabilities minus the liquidation price of any preferred shares equals book value. The total is then divided by the number of outstanding shares. If the result is higher than the current stock price, the stock is undervalued when compared to the assets’ sale value.
This provides investors with a safety net, as the sale of assets is likely to cover a major percentage of their investment even if the company goes bankrupt. The disadvantage is that the stated value of assets in financial accounts does not always correspond to what the firm would get if it were to be liquidated. As a result, likely, the book value does not adequately reflect how secure the property is.
- Price-To-Earnings Ratio- It’s the ratio of a company’s share price to its earnings from the portion of its capital raised through equity shares. It enables value investors to identify whether a stock has been underperforming but will still be lucrative shortly. As a result, it is an important metric to consider while trading undervalued stocks. The lower the P/E ratio, the higher is the Earnings per Share (EPS), keeping the share price constant and vice versa. Conversely, a higher P/E ratio implies a higher share price where EPS is constant and vice versa.
- Price/Earnings-To-Growth Ratio- Dividing the P/E by expected annual EPS growth provides another ratio that can determine how a stock is valued by investors. Price/earnings-to-growth, or PEG, often is favoured by investors over the simpler P/E ratio because it accounts for future growth. Broadly, a PEG of 1 is considered fairly valued, below 1 undervalued and above 1 overvalued. The lower the PEG value of a stock relative to other stocks in the industry, the more undervalued it is. The advantage of buying a low-PEG stock is that the stock is relatively cheap compared to its peers and has some growth prospects.
- Price to Book Ratio- The price to book ratio compares a company’s current market value or market capitalization to its book value. Often, a company could own a lot of property that’s worth a lot more than the profits it generates from its primary business operations. Hence, even though its financials are strong, the price of its stock might not reflect it. The key is to look at the assets and liabilities of a company holistically.
- Debt-equity ratio (D/E)- The D/E ratio measures a company’s debt against its assets. A higher ratio could mean that the company gets most of its funding from lending, not from its shareholders – however, that doesn’t necessarily mean that its stock is undervalued. To establish this, a company’s D/E ratio should always be measured against the average for its competitors. That’s because a ‘good’ or ‘bad’ ratio depends on the industry. D/E ratio is calculated by dividing liabilities by stockholder equity.
- Lagging relative price-performance- A company’s share price could be lower than that of its industry peers for several reasons. One of them is when a financial expert shows concern over certain financial metrics and the whiplash causes investors to sell-off and drive the price down. The price is sometimes driven so low that the stock becomes undervalued.
- Impact of News- Good and bad news both affect the stock market by changing the public’s perception of a company. Sometimes, bad news can lead to stocks becoming undervalued for a short period even though their financial fundamentals remain strong.
- Growth Potential- A company in an emerging field, or developing new technology, might be undervalued until it can prove its product’s or service’s usefulness. Determining whether the current stock price is undervalued relative to a company’s prospects can be a gamble, however. If you are right, and the company produces something that becomes consumed on a large scale, the stock price could skyrocket, providing you an above-average return on your investment. On the other hand, if the company does not produce, then the stock isn’t undervalued, it’s unlikely to appreciate.
- High dividend yield- Something that most investors choose to ignore – if a company’s dividend payment rate exceeds that of their competitors, it may indicate that the share price has dipped to “undervalued” status (about its dividend payment). Consider if the company is not financially unsettled and future dividend payments appear secure, the dividend opportunity can provide returns in the short term as well as the potential for the stock price to move higher in the future.
- Free Cash Flow- Free cash flow (FCF) is another metric that can be used to check if a stock is undervalued. FCF is the cash that a company generates through its businesses and operations after taking care of the expenditures. Cash flow to a certain extent gives us an idea of the company’s ability to fund operations and capital expenditures. Often companies use their cash flow to give out dividends and share buybacks. This is the reason why many consider cash flow as a value metric. If a company is trading at a lower value and cash flow is rising, there may be chances that share are undervalued and may have future chances of growth.
- Stock Market Cycles- The stock market moves in cycles, involving lower and upper swings. The market’s cyclical nature frequently drags good equities along with it, resulting in good stocks going “on-sale” now and then. Stocks as a whole become cheap as the market falls, as pessimism pushes stocks to severe lows. This provides an opportunity for investors to purchase stocks at a discount. Buying equities on the dips can bring long-term returns because stocks often come back up as the market cycles. However, there’s no way of knowing when a decline will cease, so there’s a chance you’ll lose more money.
Should You Invest in Undervalued Stocks?
If investors can properly calculate and analyse the various elements that are associated with such stocks, undervalued stocks have a significant potential to deliver huge profits.
Furthermore, analysing firms and their stock to see if their earnings potential is promising in the future necessitates a high level of technical understanding.
Value investors patiently await market conditions that will cause a stock market’s price to fall below its intrinsic value. These investors believe that if they can buy a share at a lower price and get a similar product, why should they buy it at face value or higher?
Investors who have substantial knowledge and expertise over the stock market’s dynamics should only indulge in undervalued stock trading.
- Natural leverage– The first advantage of investing in undervalued stocks is what is called natural leverage. By this I mean you get a high rate of return expansion without having to take on any debt. This happens because of purchasing a stock when its P/E ratio is unjustifiably low, and therefore, generating excessive future returns because of the P/E ratio moving back into alignment with rational valuations.
- Higher yield– Although this is quite self-evident, investors should be aware that when a stock’s valuation is unjustifiably low, two things happen – both of which are positive. For starters, when values are low, you can buy more shares, which means you can get more dividends because dividends are paid based on the number of shares you own. Second, while the stock’s valuation is low, the present yields available from investing in it are the largest. Obviously, this results in a higher total cumulative dividend amount over time.
- Higher total return– Although this advantage is partially redundant with advantage number 1, there is an additional principle beyond P/E ratio expansion that should be considered. When you buy a company at an unjustifiably low P/E ratio, you’ll end up earning a rate of return greater than the return that the business itself generates on your behalf as a shareholder. You can look at this as supercharging the growth potential of the business you are investing in.
- Lower risk– There’s a big difference between a stock that falls in value from being overvalued versus a stock that falls from fairly valued to undervalued. The latter will recover significantly quicker and more predictably than the former. Consequently, buying undervalued stocks defies conventional thinking that says you must take on greater risk to earn higher rates of return.
Although the benefits of investing in undervalued stocks of any kind may appear clear, I feel it is critical to grasp the complexity of how and why those benefits work.
How To Actually Find Undervalued Stocks?
Finding an undervalued stock is tricky; undervalued stocks are rarely in the news, and if they are, the news may be too negative. Both of these factors might keep a stock undervalued even though the company’s fundamentals indicate it should be trading at a higher price. While the procedures aren’t flawless, using specific tactics to identify possibly inexpensive companies might help your portfolio grow significantly if the stock regains investor and fund management favour.
It’s also about discovering low-cost stocks. The goal is to hunt for high-quality stocks that are undervalued, rather than low-quality firms that are overvalued. Good quality equities, on the other hand, will increase in value over time. Many traders and investors like to mimic Warren Buffett’s strategy, which has always been about finding undervalued stocks and those with the potential to grow over the long term.
Here are six methods for identifying a stock that is undervalued and worth investing in-
- A company’s stock price might drop dramatically in a short period of time. This is a hint for many investors to take a deeper look at what is going on within the company.
Why is that?
A company’s stock price might drop for a variety of reasons, including quarterly financial statements that fall short of market expectations. There are times, though, when the stock price drops more than is justified. Once you’ve confirmed that the company’s fundamentals are still sound, you might have found an undervalued stock in this case.
This strategy of spotting an undervalued stock could be especially valuable for cyclical sectors like commodities, which are exposed to business cycle fluctuations. That is, while the economy is expanding, the company outperforms the market, but when the economy is contracting, it underperforms.
If you are a long-term investor, a sector that is out of favour in the business cycle may be a good place to look for undervalued stocks.
- A company with consistently increasing earnings may be a solid investment for you. Identify a company that has recorded increased profits for at least the last five years. Then, using fundamental analysis, see if the company’s business is sound and has room for expansion.
A word of warning: past performance is not always indicative of future performance.
Of course, there may be a situation where the share price is already at a level that indicates that the market has factored in this possibility. Therefore, it is prudent to make a buying decision only after considering other details about the target company in addition to its earnings growth.
- If you’re looking for an undervalued company, start with the price to earnings ratio. This is how the P/E ratio is determined.
It indicates how many times a stock’s market price exceeds its earnings per share, or how much an investor is prepared to pay for one share of the company’s earnings. A larger ratio could indicate that an investor’s capital investment would take a lengthy time to recover.
A low price-to-earnings ratio may indicate a potential buying opportunity. But keep in mind that this is merely one of several aspects to consider. A low price to earnings ratio could also indicate that the market is aware of the company’s poor performance ahead of time.
- The price to book ratio refers to the number of times a company’s market price exceeds its book value of equity. This is how it is calculated.
When the P/B ratio is less than one, investors assume the company will be unable to profitably utilise its assets. It could also indicate that you’ve spotted a good bargain.
A company with a low price-to-book ratio is worth your time. You may have discovered a stock that will give substantial returns in the months and years ahead if it fits other investment criteria.
This financial ratio compares a company’s dividend payments to its current market price. A high ratio could indicate that the company is undervalued.
But it is wise to proceed with caution. Are the profits sufficient to sustain the generous level of dividends? It may also be the case that the company is unable to deploy its surplus funds effectively and is paying higher dividends because of this reason.
- Financial data and ratio analysis can push you in the correct direction, but it’s a mistake to make an investment decision solely based on the results of numerical computations. The annual report and news releases of the target company include a great deal of information. It is necessary that you obtain as much information as possible before investing your money.
- There is one non-numerical strategy that can greatly assist you in your search for a stock with the potential for capital appreciation. According to Warren Buffett, one of the most important factors he evaluates when analysing a firm is whether it can effectively hold the competitors at bay. He compares this skill to a moat around a castle. A firm should be able to ward off its competitors in the same manner as a moat keeps attackers from getting into a castle.
But it is important to remember that a “moat” cannot last forever. There are scores of companies that have lost their competitive advantage over the years. Before you take an investment decision, it is crucial that you conduct careful research not only about the company, but also about the industry that it operates in and its competitors.
- The Disruptiveness of the Business Model- Identifying the potential of new companies as well as the underdogs in the industry is another way to find undervalued stocks in Indian in 2021. Look at the companies offering disruptive products and services in the industry or creating a new market or market channel.
Where The Buck Stops…
In India in 2021, undervalued stocks offer a wonderful opportunity to make strategic investments with high returns. To properly uncover undervalued stocks, you must strike a balance between analysing a business’s important measures and your analytical judgment about the impact of changes in the company, industry, or market.
Short-term gain-seeking investors may be disappointed because undervalued stocks take time to exhibit their genuine worth. Investing in undervalued stocks, on the other hand, can be a profitable experience if you are a patient investor who has done extensive research and believes in the fundamental soundness of the company.