Undervalued stocks is a term used to describe stocks or securities whose present market value is less than their intrinsic value. The undervaluation of stocks can be caused by a variety of reasons which can range from sector-specific slowdown, socio-economic factors or a slowdown of the entire market in general. Investing in undervalued stocks is also known as value investing. This method of investment was pioneered by American investor Benjamin Graham. However, the person who truly made it a global term is Graham’s student and perhaps the world’s most popular investor, Warren Buffet. In this post, we will take a look at some of the key aspects of undervalued stocks and value investing before you can start investing your money in the 10 best undervalued stocks available today.
Undervalued Stocks: Key things to know
What are Undervalued Stocks?
A simple example of an undervalued stock is as follows. Let’s assume that a particular company’s stock is currently being sold at $1,000 a share. However, the intrinsic value of the stock is $2,000. Hence this stock can be considered to be an undervalued stock. The stock might be selling at a much lower price than its potential because of numerous possible reasons. One of those reasons could be volatile market conditions. It could also be caused by a worldwide market slowdown caused by an epidemic like the Coronavirus crisis of 2020.
What are the Factors on which the Intrinsic Value of Stocks Depends?
Value investors use several variables to determine a stock’s intrinsic value. The process needs extensive research on the investors’ end and they need to study factors such as the company’s yearly fiscal performances, its recent revenue generation, along with its cash flow and annual profit. The valuation also accounts for the company’s brand, its revenue model and what has caused the undervaluation of its stocks. The research is usually carried out through news about the developments in the market associated with the firm’s industry.
While these are the variables which value investors need to consider when purchasing an undervalued stock, any conclusive data regarding these variables is reached through the following:
- Price-to-earnings ratio (P/E ratio)
The P/E ratio is nothing but the ratio between the prices of a company’s share and the earnings generated from the portion of the capital raised through equity shares. It allows value investors to determine whether a stock is underperforming only under current circumstances and shall be profitable in the near future. This makes it an essential metric when it comes to trading undervalued stocks.
For instance, per unit price of each share issued by Company A is listed at $50, and its Earnings per Share is $12. Hence, its P/E ratio would be – $50/12 or $4.5. So, an investor has to invest $4.5/share to earn a yield of $1/share.
The lower the P/E ratio, the higher is the Earnings per Share (EPS), keeping 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-to-book-ratio (P/B ratio)
The P/B ratio is the ratio that exists between a firm’s book value (total value of assets/total number of shares in the market) and the share price per unit. It provides a distinctive estimation of a company’s fiscal standing and whether it possesses the means to earn profits in the future.
In case the market value of such shares is lower than its book value, it denotes undervalued stocks; with the exception being that the company is struggling with a fiscal crisis.
- Net cash flow
It is the cash flow which is left after all necessary cash outflows have been deducted. These cash outflows include both operating expenses and capital expenditures.
It is a primary determinant of whether a company’s stock is undervalued or not. If the company has net or free cash flow, it can invest in R&D, pay off the existing debts, launch new products and pay timely dividends to its shareholders as well.
A stock’s intrinsic value can also be analysed using a wide range of other factors and metrics. Some qualitative fields based on which it is determined whether the stock of a company is undervalued or not are:
- The earning history of a company.
- A company is not indulged in any financial scam.
- The products offered by a company and whether such products have the potential to sustain and be profitable in the future.
- A company’s credit rating which denotes its debt-reliance.
- A company’s profit or loss during the previous recession.
These fields and other factors related to these fields are analysed by value investors in order to determine if a firm’s stock is undervalued.
Who should Invest in Undervalued Stocks?
Undervalued stocks have considerable potential to yield substantial returns if investors can properly research and analyse the different variables which are related to such stocks.
Significant technical knowledge is mandatory for someone to analyse a firm and its shares shows a future earning potential.
Value investors always wait for market conditions which push the price of a stock below its intrinsic value i.e. make it undervalued. All value investors believe that if it’s possible to purchase a share at a lower price than the intrinsic value, why buy it at its intrinsic value or even worse, at a higher value.
For instance, the market value of stocks issued by a company is listed at $75, whereas, the share’s intrinsic value was estimated at $100. Hence, it is currently undervalued. An investor decides to purchase 1000 shares at $75 and waits for the prices to restore to its intrinsic value. Upon analysis, she reaches the conclusion that the share prices might cross $100 and peak out at $108. Upon selling the shares, her per unit profit is $(108 – 75) or $33 and her total profit stands at $(33 x 1000) = $33000.
Undervalued stock trading is only for investors who possess a lot of knowledge about the dynamics of the stock market. It’s not for beginner investors.
What are the advantages of Undervalued Stocks?
Some of the key advantages of undervalued stocks and shares are:
- The prices at which you buy undervalued stocks usually return to their intrinsic value. Hence, a profit is more or less guaranteed.
- It presents an opportunity to purchase shares at low prices from well-established or promising companies.
- If the undervalued stocks are bought by a seasoned investor after doing the prerequisite research, the risk is very low because undervaluation is usually cyclical and the share prices usually attain their intrinsic value.
What are the disadvantages of Undervalued Stocks?
Some of the most glaring disadvantages of undervalued stock and shares are:
- It’s not feasible or advisable for all investors to invest in undervalued stocks.
- The research required for investing in undervalued stocks is exhaustive and cumbersome, making it tough for the average investor to do it.
- Investors can also make mistakes in their analysis.
As the above mentioned reasons elucidate, beginner investors should stay away from undervalued stocks. They are better off putting their money in financial instruments that are less risky and don’t require expert level knowledge to invest in. For investors looking for short term gains these may not prove to be fruitful as undervalued stocks need time to show their true worth. However, if you are a patient investor who has done exhaustive research and believes in the fundamental soundness of the business, then investing in undervalued stocks could be a rewarding experience.
Is it good to buy undervalued stocks?
For long-term investors, value investing is a great strategy. Investors of undervalued stocks and shares can see a major portfolio boost in scenarios where the stocks experience great price appreciation. Moreover, undervalued stocks are a great bargain to purchase as well.
How do you know if a stock is undervalued?
On the company’s balance sheet or a stock website, look for something called the “book value per share”. Once you get that, look for the ratios. All the ratios below one represent undervalued stocks. To calculate the P/B ratio, take the current price of the share and divide it by the book value per share. For example, if a share’s current price is $60 and the book value per share is $10, the P/B ratio comes out to be 6.
What is overvalued and undervalued stock?
When a stock or share trades at a price that is close to its intrinsic value, it is considered fairly valued. However, when the trade is carried out a price way higher than the intrinsic value, it is known as an overvalued stock. Conversely, if the trade is carried out at a value much lower than the intrinsic value, it is known as an undervalued stock.
Are stocks still overvalued?
Based on the latest S&P 500 monthly data, the market is overvalued somewhere in the range of 48% to 126%, depending on the indicator, down from 85% to 152% the previous month.
How do you tell if the market is overvalued?
The overvaluation of a stock is usually identified using the relative earnings analysis. This metric compares the earning with a market value such as price. The most popular comparison of this type is the P/E ratio. It indicates the ratio between a company’s earnings and its stock price.
Is Warren Buffett a value investor?
Perhaps the world’s biggest proponent of value-investing, Berkshire Hathaway chairman Warren Buffet has always opined that buying stocks at lower than their intrinsic value is the essence of value investing. His teacher and guide Benjamin Graham used to call the difference between discount of the market price and the intrinsic value as the “margin of safety”. As a matter of fact, Warren Buffet has built a large portion of his wealth with the help of value investing. However, just because it has worked for him, it doesn’t mean that value investing is easy. You need to have significant knowledge and a good idea of the field before you start buying undervalued stocks in order to generate wealth.