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.

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.

Why undervalued stocks for investment

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. 

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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