In the stock market, the stocks that are undervalued are referred to as undervalued stocks. There are various ways to determine if a stock is undervalued in the stock market; the important thing to do is to carry out the needed research and use some financial metrics to evaluate the stocks. In this article, I will use these ratios to show you how to determine if a stock is undervalued or not.
What does it mean when a stock is undervalued? Undervalued is a financial term used during the valuation of stocks to refer to a security or other type of instrument that is trading in the market at a price that is presumed to be lower than the true intrinsic value of the investment.
A company’s intrinsic value is the present value of the free cash flows expected to be generated by the company. A stock can be considered undervalued by investors after looking at the financial statements of the company and analyzing the company’s fundamentals. Analyzing fundamentals such as profit generation, cash flow, return on assets, and capital management can help estimate the intrinsic value of a stock.
Undervalued stocks trade below their intrinsic value in the stock market
The same way some stocks are considered undervalued in the stock market is the same way some are deemed overvalued. Overvalued stocks are known to be priced in the market at a higher price than their perceived value. Some investors are not interested in such overvalued stocks and prefer buying stocks that are undervalued. Such an investment style is known as value investing.
These kinds of investors look for different kinds of stocks in the stock market such as value stocks that seem to be trading at a lower price than their intrinsic value and invest in them. A typical example of a value investor is the famous American business magnate, investor, and philanthropist, Warren Edward Buffett.
What is an undervalued stock?
An undervalued stock is a stock that is trading at a price that is significantly below its assumed intrinsic value. When a stock is undervalued in the market, it is sold at a price that is below the investment’s true intrinsic value.
For example, if a stock is worth $100 based on predictable future cash flows but is trading at $50 in the market, the stock is assumed to be an undervalued stock. Such a kind of discount associated with the stock is what makes them attractive to investors. Investors invest in undervalued stocks because they assume that the market prices of the stock will correct over time to reflect the true fair value of the stock, thus, creating opportunities for profit.
It is important to note that a cheap stock may not necessarily be an undervalued stock. Finding undervalued stocks entails looking for quality stocks that are selling at a price that is below their fair value. Therefore, it is not about looking for just any stock that has a low price, but rather looking for quality stocks because a good quality stock will definitely rise in value in the long run.
Why are some stocks undervalued in the market?
There are so many reasons why stocks can become undervalued. The major factors behind the undervaluation of stocks include negative press, recognisability of the company, and market crashes.
Most undervalued stocks right now are trading at a lower price than their actual value due to any of the following reasons:
- Sudden bad news: Bad press, as well as economic, political, and social changes, can affect the prices of some stocks and make them undervalued. A discrete event such as a public relations disaster or missed guidance that is not even related to the company’s fundamentals can cause the market to drive the company’s share price to become low, therefore becoming undervalued.
- Changes to the market: Some changes to the market such as market crashes or corrections could cause the prices of stocks to drop.
- Cyclical fluctuations: There are alternating periods of contraction and expansion in the business cycle known as cyclical fluctuations which can last 18 months or longer from the peak to the trough of the cycle. Some industries are very sensitive in such periods as consumer and business demand tend to drop during contraction and rise during expansion e.g cyclical stocks. Hence, the stocks of such industries perform poorly over certain quarters, which affects the prices of their share. However, when the economy is booming such stocks pick up.
- Misjudged results: Stocks can become undervalued when they don’t perform as predicted. They are misjudged by the market, thus, causing their price to drop.
Furthermore, value investors search for undervalued stocks based on their current price relative to their intrinsic value. They view undervalued stocks as stocks with a lot of potential or perhaps with the capabilities to disrupt entire industries. Nevertheless, finding undervalued stocks would require an inherent knowledge of each industry and how the stock in question can outperform in its industry. There are some stock valuation methods that investors have to carry out to determine if a stock is undervalued.
How to determine if a stock is undervalued
- Look at the company’s market cap
- Find the price-to-earnings ratio (P/E)
- Evaluate the debt-equity ratio (D/E)
- Find the return on equity (ROE)
- Check the company’s earnings yield
- Check the company’s dividend yield
- Calculate the current ratio of the company
- Evaluate the price-earnings to growth ratio (PEG)
- Calculate the price-to-book ratio (P/B)
- Evaluate the price-to-sales (P/S) ratio
- Check the company’s free cash flow
How can you tell if a stock is undervalued? Since undervalued stocks trade below their worth, investors can use several metrics to gauge a stock’s worth. Some investors make use of standard metrics, such as price to earnings, price-to-sales ratio, price to cash flows, etc. While some may just look at the price of the stock relative to the company’s future growth prospects, or look at where a stock is selling relative to its 52-week high price.
In order to determine if a stock is undervalued, consider evaluating if the company is consistently profitable and examine its long-term growth prospects. When investing in undervalued stocks, in order to ensure the long-term generation of wealth, it is best to focus on companies with strong business fundamentals and not just to evaluate the cheapness of a company’s price-to-earnings ratio. No matter the economic challenges or competition faced, high-quality businesses will likely outperform very well over the long term.
Therefore, in order to determine if a stock is undervalued, investors and analysts can use fundamental indicators to evaluate the stock’s true value. They can use the price-to-earnings ratio, price-to-sales ratio, and several other financial metrics to evaluate the value of a company depending on the company’s maturity. Here are several methods that analyze how to determine if a stock is undervalued:
Look at the company’s market cap
How to screen for undervalued stocks is to look at the company’s market cap. The market capitalization of a company is the total value of the company’s shares of stock. Therefore, a market cap of a company can give you an insight into the true value of the company’s stocks and how profitable the company is.
The market cap is calculated by multiplying the current price of a single share with the total number of outstanding shares. Some companies have a large market cap and issue out large-cap stocks, while other companies issue out mid-cap stocks and small-cap stocks depending on the size of their market cap.
Undervalued stocks don’t necessarily have to come from the biggest companies out there. They could come from mid-cap or small-cap companies, or even growth-oriented companies (growth stocks) that trade for less than their peers. Therefore, when investors find stock from a company that has an impressive market cap but trades at a discounted price, they tend to mark the stock as undervalued.
How to tell if a stock is undervalued with a P/E ratio
How to determine if a stock is undervalued is to look at the price-to-earnings (P/E) ratio of the company. The P/E ratio of a company is calculated by dividing the stock price of the company by its earnings per share. This earnings per share ratio is calculated by dividing the company’s earnings from the past 12 months by the number of shares issued and held by stockholders.
The price-to-earnings ratio is the best-known metric used for stock valuation, especially when comparing the valuations of companies in the same industry. This ratio can be used to determine if a stock is undervalued as it tells investors if the stock price accurately reflects the company’s earnings potential or not.
So, if the company has a lower P/E ratio there is a chance that investors are getting valuable stocks at a discounted price. This means that undervalued stocks tend to have low P/E ratios as the ratio suggests a stock that is undervalued or that the company is doing very well compared to its past trends.
How to see if a stock is undervalued with the D/E ratio
How to determine if a stock is undervalued is to calculate the debt to equity ratio of the company. A D/E ratio greater than 1, tells that most of the company’s assets are financed through debt. Whereas a debt-equity ratio of less than 1, tells investors that the company’s assets are primarily financed through equity.
Investors can assess the debt to equity ratio of a company to understand how much debt financing the company uses to run its operations. There is an average debt to equity ratio by the industry that one can use as a yardstick. However, even though the debt-equity ratio varies from industry to industry, a ratio that is less than 2 is considered a healthy ratio.
A company with a higher D/E ratio than its industry average would have difficulties securing additional funding from lenders or shareholders. Therefore, a stock that is trading at a discounted price that has an ideal debt to equity ratio tells us that the company is a very low-debt business with a sound financial structure. This would appear as a good investment.
Nevertheless, some companies with high D/E ratios use lots of debt to finance their growth which could potentially generate more earnings and benefit shareholders. This is only beneficial if leverage increases earnings by a greater amount than the debt’s cost (interest). But if the cost of debt financing is greater than the increased income generated, there may be a decline in the value of the company’s shares. Therefore, a low D/E is a safer investment.
How to determine if a stock is undervalued with ROE
The ROE (return on equity) can be used to determine if a stock is undervalued. The ROE is a metric in percentage that measures a company’s profitability against its equity. It is calculated by dividing the net income of the company by its shareholder equity. A high ROE could tell that the stocks are undervalued. This is because the company is generating a lot of income compared to the amount of shareholder investment.
Check the company’s earnings yield
Checking the company’s earnings yield can be used to determine if a stock is undervalued. The earnings yield of a company can be seen as the reverse of the P/E ratio. Unlike the P/E ratio which is calculated as price per share divided by earnings per share (EPS), the earnings yield is calculated as EPS divided by the price per share. Some traders categorize a stock as being undervalued if the earnings yield of the company is higher than the average treasury yield (the interest rate that the US government pays to borrow money).
Check the company’s dividend yield
A company’s dividend payment is the portion of the profit that companies pay to their stockholders compared to their share price. The dividend yield is calculated as a percentage which is gotten by dividing the annual dividend by the current share price. Companies with solid dividend yields are attractive to traders and investors because it indicates more stability and substantial profits.
How to determine if a stock is undervalued is to check the dividend yield of the company. If the dividend yield of the company exceeds its competitors, the stock price of the company could be undervalued relative to its dividend. Such stocks are said to be undervalued dividend stocks. However, such a situation could also mean that the company is paying unsustainable dividends, so one has to be careful.
How to know if a stock is undervalued with the current ratio
The current ratio of a company is an evaluation of its ability to settle its short-term liabilities with its current assets. Determining if a stock is undervalued can involve calculating the current ratio of the company. This ratio is calculated by simply dividing the current assets of the company by its current liabilities.
A current ratio greater than 1 shows that the current assets of the company are greater than its liabilities. This can be considered a desirable situation for investors and creditors. The higher the current ratio of a company, the more the ability of it to pay its obligations due to the fact that it has a larger amount of short-term asset value compared to the value of its short-term liabilities.
Conversely, the lower the current ratio, the lesser the ability of the company to pay its obligations and the higher the probability that the company’s stock price will continue to drop. The stock price may even drop to the point of it becoming less valued. Therefore, a stock with a higher current ratio that is trading less than its intrinsic value is definitely a good buy.
How to calculate if a stock is undervalued using the PEG ratio
How to determine if a stock is undervalued can involve also calculating the PEG ratio. The PEG ratio means a price-to-earnings-to-growth ratio. The ratio is similar to the P/E ratio but rather focuses on determining the relative trade-off between a stock price, the earnings generated per share (EPS), and the company’s expected growth.
This ratio is calculated by dividing the P/E ratio by the growth rate of its earnings for a specified period of time. When comparing companies with different growth rates, it is better to use the PEG ratio. In order to determine if a stock is undervalued, one can calculate the PEG ratio of the company. A PEG ratio of 1.0 or lower suggests that the stock is fairly priced or even undervalued, whereas a PEG ratio above 1.0 suggests that the stock may be overvalued.
How to determine if a stock is undervalued with the P/B ratio
How to evaluate if a stock is undervalued is to find the price-to-book value ratio (P/B). The book value of a company is thought of as what will be left theoretically if a company stops operation and sells all its assets. The P/B ratio calculates the share price of the company as a multiple of its book value, thus, helping to identify undervalued opportunities. Investors can use this ratio to assess whether a stock is valued properly. The ratio gives an insight into whether you’re paying too much for what will be left if the company went bankrupt.
The P/B ratio divides the market cap of the company by its book value of equity or divides the current share price of the company by its book value per share. For years, this ratio has been favored by value investors and has been extensively used by market analysts. Traditionally, a P/B ratio under 1.0 indicates a potentially undervalued stock. Value investors consider such value as a good price-to-book value ratio, though, they usually still consider stocks with a P/B value under 3.0 as their benchmark.
Therefore, from a P/B standpoint, a company with a lower price-book ratio could indicate an undervalued stock whereas, a company with a high price-to-book value ratio could indicate an overvalued stock.
How to evaluate if a stock is undervalued using the P/S ratio
Another method used to determine if a stock is undervalued is to calculate the price-to-sales ratio. This ratio is calculated by dividing the market capitalization of the company by its total sales or revenue over the past 12 months. The P/S ratio is used to know whether the stock is overvalued or undervalued, especially when the company is yet to earn a profit.
Investors that are looking for undervalued stocks tend to be attracted to companies with a low price-to-sales ratio. It may be an indication of a good investment if the P/S ratio of a company is lower than the companies compared in the same industry that is profitable. Therefore, investors may consider buying the stock due to the low valuation.
How to know if a stock is undervalued with free cash flow
Value investors looking for undervalued stocks can also scout for companies with high free cash flow. A company’s free cash flow is the amount of cash left after the company has taken care of capital expenditure and operational expenses. The generation of free cash flow means the company has money left over to invest in the company’s future, issue share buybacks, pay dividends or rewards to shareholders, and pay off debt. Therefore, an undervalued stock candidate may be a company with plenty of free cash flow and low relative share prices to its competitors, probably due to weak earnings reports.
Is it good to buy undervalued stocks?
Traders buy undervalued stocks with the hope that over time, the stocks will probably outperform the overall stock market. There are definitely pros and risks to such an investment style. Purchasing undervalued stocks can turn profitable in the long run. This investment has proven to be a good investment strategy for people with long-term investment goals. They buy these stocks to earn steady, reliable returns over a very long period of time and not for quick gain over the short term.
However, the downside to buying undervalued stocks is that the investment can be risky because the market has to alter its perception of the company for it to be profitable. These stocks may need some time to emerge from their underpriced position which may never happen. The stocks that are undervalued may decrease from their current value or may never get the chance to become appropriately valued. Therefore, it is best to diversify your stock portfolio by buying shares of many different companies to help offset losses and underperformance.
A video explaining how to determine if a stock is undervalued
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