How to find an Undervalued Stock?

An expert trader invests in assets that have a good price, market value, and potential to grow.

But a pro trader invests their time in finding undervalued stocks with strong fundamentals and bets against the market. It’s like betting on a horse everybody says would lose and winning the game.

Walter Schloss couldn’t deny his unwavering interest in undervalued stocks. He famously quoted, “We like to buy stocks which we feel are undervalued and then we have to have the guts to buy more when they go down.”

Undervalued stocks give investors an opportunity to compound more relative to already high-valued stocks due to their low intrinsic value.

The question is, what are these undervalued stocks and how do you find them?

Let’s figure it out without any further ado.

What Are Undervalued Stocks?

Basically, they are the underdogs of the stock market with really good potential to grow but haven’t been noticed.

In simpler terms, undervalued stocks are those securities that have a lower price than their actual ‘fair’ or ‘intrinsic’ value. These are stocks of not-so-popular companies that show good growth and profits in their quarterly reports consecutively. However, their stock price remains the same, due to either lack of demand or unidentified brand value among investors.

Let’s take an example. If a company has grown approximately 30% in the last two half-yearly and three quarterly reports with only a rise of 1-10% in the stock price, it would be counted in the undervalued stocks list.

Traders or investors often overlook these companies’ stocks, leading to availability at cheaper prices, despite remarkable growth. The motto of investing in such stocks is that during the time of market correction, the stock will show its fair value, creating opportunities for benefit.

Some traders think undervalued stocks are the ones that cost less, but spotting an undervalued stock is more than just finding the cheap stock. It is rather the quality that the stock carries than its price. Such traders strongly deduce that a good quality stock will always emerge, even from the grave, if kept for the long term.

Why Do Stocks Become Undervalued?

But why does it happen the way it happens?

The question struck our heads when we observed people missing out on a pool of either opportunities or risks. Well, there are several reasons that affect the stock value, making them look undervalued. Such as;

• Adverse Market Mood: Market corrects itself in strange ways. Such corrections or crashes could cause the stock price to drop.

• Negative Media: Bad news is not bad news until it is related to you closely. But stock market bad news, negative press, social, political, and economic changes can impinge the price of share.

• Market Prediction Gone Wrong: In most of the cases, misjudged results of stocks or industry takes the price downward with itself.

• Cyclical Fluctuations: Some stocks may be affected by the annual or specific quarter reports, showing an undervalued performance within a period of time.

Besides, there are several other causes that lead to price domination, such as sector performance, demand-supply dynamics, etc.

Why Undervalued Stocks for Investment

“Multiple people get interested in stock when everyone else is, but the time to get interested is when no one else is”– Warren Buffett

Undervalued stocks can look appealing to investors who are seeking a good balance between risk and reward. Here is a closer look at the reasons why undervalued stocks hold a good potential for growth opportunities with inherent risks involved:

Potential growth

The key aspect of investing in undervalued stocks lies in their potential for significant price appreciation. An investor can make trades with these stocks with the expectation of gaining substantial returns when the market recognizes its true value. 

Compared to fairly valued or overvalued stocks, undervalued stocks have the potential to deliver higher returns on investment. As the stock price adjusts to its intrinsic value, investors can benefit from both capital appreciation and potential dividend payouts.

Risk and reward

Risk and reward are two sides of the investment coin. Both are inherently linked – the higher the potential reward, the greater the risk one can likely take on. Investing in undervalued stocks is a good choice for making big margins on the market miss of opportunity. Although traders suggest calculating the risk, it is crucial to conduct the fundamental study, company analysis, and market value before making the big leap in investment.

Undervalued stocks are the hidden gems of the stock market that hold huge potential and more growth opportunities, however, it is just another face of speculation on big gains. These stocks could soar if the market recognises its true value, but come with added risks. It is highly crucial to do your research and fundamental study before speculating on any stock’s growth, whether it’s undervalued stocks or blue-chip companies. 

7 Ways to Find an Undervalued Stock

How would one know which stock is undervalued and has strong fundamentals? Well, to dive deep, you need to learn the basics – fundamental analysis of a stock. Here are six major indicators or analysis factors to spot an undervalued stock:

Demand and Supply Theory

Demand-supply dynamics, a technical analysis method, allows investors to analyze historical price charts and identify key zones across multiple timeframes. This analysis helps them find potential entry points, even when the current stock price appears to be at a low (bottomed-out).

By studying price action, sector trends, and other factors, investors can gain insights beyond just the current price dip. A price drop from a high-timeframe supply zone might seem like a sign of an undervalued stock, but demand-supply experts might view it as a buying opportunity due to the potential for a reversal. The 2020 example of BHEL illustrates this point. While the stock reached low, demand-supply experts saw a bullish opportunity and potentially benefited from the subsequent price surge.

Basically, you’re looking for areas where the stock might be oversold (low demand) and ripe for a rebound due to increased buying activity (higher demand). While current price dips might seem scary, demand-supply analysis can help identify potential entry points for undervalued stocks poised for growth.

Price-to-Earnings Ratio (P/E):

P/E ratio is one of the most common and popular ways to calculate the true value of a stock. It measures the stock’s current share price and divides it by the earnings per share (EPS). In brief, it tells the difference between earning per share with current market value, speaking of its true value.

Mostly undervalued stocks are identified with a low PE ratio. To know the value of stock, it is important to compare the PE ratio of a company with its competitors and industry’s PE ratio to avoid partial judgement.

Price-Earnings to Growth Ratio (PEG):

More accurate than the P/E ratio, the PEG ratio highlights the relative trade-off between earnings per share (EPS), the company’s expected growth, and stock price. But the P/E ratio plays a vital role in the calculation which is divided by its ‘earning growth rate’ to get the PEG value. For instance, XB’s P/E ratio is 10 (price per share divided by EPS) and its annual earnings growth rate is approximately 15%. The PEG ratio would be about 0.67 (10/15%).

If a company has a low PEG ratio it could be an indicator of an undervalued stock.

High Dividend Yield:

One of the most crucial parts which often investors overlook is high dividend yield. If a company’s dividend payment surpasses its competitors, it may be a green flag for another “undervalued stock”.

Think of it this way, if a company is not financially strong and secure future dividend payment, investors can compound money through dividend for both short and long-term investment goals.

To calculate the dividend yield, you need to divide the annual dividend by the current stock price of the company. Strong dividend yields show stable profits and solid dividend yields.

Price-to-Book Ratio (P/B):

Many investors use this strategy to locate undervalued companies and compare market caps to its book value. The price-to-book ratio compares the book value of a firm with the current market price.

To calculate the P/B ratio, divide each share market price by the book value per share. For instance, XB’s share price is RS60, and its book value is RS80. The P/B ratio would be equal to 0.75 (RS60/RS80).

Often if the P/B ratio is found lower than 1, the indices or stock could be considered as undervalued.

Lagging Relative Price-Performance

One of the major reasons for the decreasing share price of specific industries or companies is contradictory statements from financial experts. When financial wizards make statements against the industry of financial metrics, it generally creates whiplash, leading to major sell-off, pushing the price downward. The impact can extend so low that the stock looks undervalued. It is suggested to review your screener for an option that allows you to compare histories of individual stock prices over different time periods against other market indices or individual stocks.

Return-on-Equity (ROE)

ROE or return-on-equity is a percentage that calculates the revenue of the company against its equity. For measuring the value, divide the net income by shareholder equity.

For instance, assume XB enterprise with a net income of 90 Cr and stockholder equity of 500 Cr. Henceforth, the value of ROE is about 18% (90 Cr/500 Cr).

If a firm has a high ROE value, it could mean that the share is undervalued as the company is making more income in comparison to shareholder investment.

Also Read: Penny Stocks

How to Identify Undervalued Stocks Using Financial Statements?

Financial statements offer vital data to investors for identifying undervalued stocks. By examining the key financial data, investors can assess a company’s profitability, financial strength, and true market worth through multiple financial ratios. Numerous financial ratios for undervalued stocks help investors track organisational performance and real business value. These financial metrics and ratios are given below:

1. Price-to-Earning Ratio (P/E)

The P/E ratio divides the stock price by earnings per share (EPS).  A decreased P/E ratio compared to industry rivals may signify an undervalued stock.

2. Price-to-Book Ratio (P/B)

This ratio compares market value to book value per share. A P/B ratio under 1 means the market is pricing the stock below its book value, which indicates possible undervaluation.

3. Price-Earnings to Growth Ratio (PEG)

The PEG ratio is calculated by dividing the P/E ratio by the earnings growth rate. This ratio is more correct than P/E because it comprises the growth rate of the company.

4. Debt-to-Equity Ratio

The ratio compares total debt to shareholder equity. Less debt means safer investment, and the company is financially stable. A decreased debt level signals lower financial risk and stronger financial soundness.

5. Enterprise Value to EBITDA (EV/EBITDA)

The ratio measures the total value of the company to its operating earnings before amortisation, taxes, interest, and depreciation. When this ratio is below the industry average, then the stock tends to be underpriced.

6. Earnings Yield

It indicates the amount of profit a company gets for every dollar or rupee invested. A higher investment return shows that the stock offers better value as compared to its market price.

7. Current Ratio

The current ratio compares a firm’s ability to cover immediate payments with current assets. 

A strong current ratio signifies financial soundness and sufficient liquidity, which lowers investment risk. 

8. Free Cash Flow Yield

This ratio represents how much cash a firm generates as compared to its stock price. A high cash flow yield signifies the financial soundness of a company.

9. Return on Equity (ROE)

ROE calculates how much profit a firm generates from shareholder investments. Strong ROE indicates effective use of shareholder funds and may signal undervaluation when the stock price fails to match this efficiency.

These financial ratios for undervalued stocks assist investors in making insightful decisions by examining profitability, valuation and healthy financial position. 

Key Insight: Investors have to be cautious of value traps, where a low stock price indicates a fundamental business problem. 

Difference Between Undervalued Stocks vs Overvalued Stocks

Understanding undervalued stocks vs overvalued stocks helps investors to compare real company worth and market pricing. 

Basis	Undervalued Stocks	Overvalued Stocks
Meaning	Undervalued stocks are those stocks which traded below their true value	Overvalued stocks are those that trade above their true value
Price vs Value	The stock price is lower than its actual worth	The stock price is higher than its actual worth
Company Fundamentals	It has a strong financial performance	It has a weak financial performance
Investment Potential	It has a higher chance of long-term price growth	It has a higher chance of price decline if expectations are not met
Market Perception	The market has not fully recognised the company’s potential	The market has unrealistic expectations about the company
Risk Level	It is lower when supported by strong fundamentals	It is higher because the stock price may fall to match its true value.
Investor Interest	It attracts value investors	It attracts those investors who focus on short-term price movements
Example Situation	A financially strong company that is temporarily ignored by the market	A company whose stock price increases significantly due to over-expectation

Key Insight: Undervalued stocks are frequently ignored due to negative market sentiment, short-term operational setbacks, or reduced investor participation.

Common Mistakes Investors Make While Picking Undervalued Stocks

Investors make some common mistakes while choosing undervalued stocks, which resulted to bad investment outcome. 

1. Ignoring Business Quality

Investors only focus on valuation and price, whereas ignoring competitive advantage, management strength, and business model resulted to poor investment decisions.

2. Falling for Value Traps

Some stocks appear low-priced because they face major problems and may keep falling.

3. Relying on a Single Ratio

Relying on only one financial ratio may not depict the full value of a company.

4. Ignoring Future Growth Prospects

Not analysing the growth potential and future earnings of the company can lead to investing in businesses with limited long-term opportunities.

5. Overlooking Debt Levels

Excessive borrowing can be risky because it make company’s financial position less strong.

Undervalued Stocks vs Growth Stocks

Understanding undervalued stocks vs growth stocks assists investors in selecting the correct investment strategy based on risk level, value, and growth potential.

Basis	Undervalued Stocks	Growth Stocks
Meaning	Undervalued stocks are those stocks that trade below their true value	Growth Stocks are those stocks that are expected to grow revenue and earnings at a faster rate in the market
Investment Focus	It focuses on current value and fundamentals	It focuses on financial growth and future expansion
Risk Level	Riks is lower when supported by strong business stability and financial performance	Risk is higher because of dependence on future performance
Market Perception	Undervalued stocks are not fully recognised by the market	Growth stocks attract strong attention from the market and investors
Price	Price is lower than the actual worth	Price is higher because of future growth expectations
Dividend Payment	It pays regular dividends	It reinvests profits rather than paying dividends
Return Potential	In these stocks, returns mainly come from value recognition and price correction	In these stocks, returns mainly come from business expansion and earnings growth
Investor Type	It is chosen by value investors	It is chosen by growth investors
Example Situation	A stable company trading below its actual worth	A rapidly-growing firm advancing its technology, increasing revenue, or market share

Risks of Investing in Undervalued Stocks

Undervalued stocks may appear attractive, but they can involve numerous risks that may impact long-term returns.

1. Slow Price Recovery

The market may take time to realise the true value of stocks, which can lower potential results. 

2. Market Sentiment Risk

Economic conditions and negative market movements can keep stock prices low even if the company is financially stable.  

3. Weak Business Performance

Some undervalued stocks have weak competitive strength, reduced earnings, or poor management. 

4. Value Traps

Some stocks are undervalued because the company has major financial difficulties, and the price continuously decreases. 

Wrapping It All

Undervalued stocks are like the undiscovered gold mines, if you know the right spot to dig, you get the jackpot. These metrics help measure the true value of undervalued or overlooked stocks, but are not all the major factors as every investor has their own styles and combination of analysis they use for the fundamentals to know whether a stock is good or not. There is no typical measure that you need to comply with, rather focus on the right strategy suitable as per your understanding to locate the market loophole and make advanced investment decisions.

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