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What are Undervalued Stocks?
Undervalued stocks or securities are equity shares that have a market value lower than their intrinsic value. The undervalue could be due to a host of reasons ranging from sector-specific, socio-economic or overall market slowdown.
For instance, the share of Company A is selling in the market at a price of Rs. 1000; however, its intrinsic value is estimated to be Rs. 2000. Hence, Company A’s shares are valued lower than its potential owing to volatile market conditions.
The process of investment in undervalued stocks is known as value investing. It was pioneered by Benjamin Graham and later followed by his student and protégé Warren Buffet.
What are the Factors on which the Intrinsic Value of Stocks Depends?
Value investors use several variables to determine a stock’s intrinsic value. It involves extensive research and studying factors such as a company’s fiscal performance over the years, its revenue generation in recent times, cash flows, profits, etc. The valuation also takes into account the brand of a company, its revenue model, why its stocks are undervalued – through news, developments in the market related to such company’s industry – the industry to which such company belongs, etc.
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)
It is the ratio between a company’s share prices and its earnings 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. Hence, it is a crucial metric when trading in undervalued stocks.
For instance, per unit price of each share issued by Company A is listed at Rs. 50, and its Earnings per Share is Rs. 12. Hence, its P/E ratio would be – Rs. 50/12 or Rs. 4.5. So, an investor has to invest Rs. 4.5/share to earn a yield of Re. 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)
It is the ratio between a company’s book value (total value of assets/total number of shares in the market) and per unit share price. 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. In case, a company possesses net or free cash flow, it has the financial capacity to invest in R&D, pay existing debts, launch new products, provide timely dividends to shareholders, etc.
In addition to this, there are several other factors or metrics which analyse a stock’s intrinsic worth or value.
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.
Value investors analyse these fields and other related factors and metrics to determine whether the stock of a company is undervalued or not.
Undervalued stocks have considerable potential to yield substantial returns if investors can properly reckon and analyse the different variables which are related to such stocks.
Besides, analysing companies and its shares to determine whether each organisation’s earning potential shows promise in the future requires significant technical knowledge.
Value investors duly wait for market conditions which will render the market price of a stock below its intrinsic value. These investors follow the principle that if they can purchase a share at a discounted price, where they procure a similar product, why should they purchase it at its face value or higher.
For instance, the market value of stocks issued by Company B is listed at Rs. 75, whereas, the share’s intrinsic value was estimated at Rs. 100. Hence, it is currently undervalued. Investor A decides to purchase 1000 shares at Rs. 75 and waits for the prices to restore to its intrinsic value. She analyses and reaches a conclusion that such share prices might go beyond Rs. 100 which ultimately peaks at Rs. 108. Hence, when she sells these shares, her per unit profit is Rs. (108 – 75) or Rs. 33 and her total profit stands at Rs (33 x 1000) = Rs. 33000.
Investors who have substantial knowledge and expertise over the stock market’s dynamics should only indulge in undervalued stock trading.
Advantages of Undervalued Stock
Some of the key advantages of undervalued shares are –
- Prices of undervalued stocks automatically return to their original value or intrinsic value, which is why profits are assured.
- It presents an opportunity to purchase shares at low prices from well-established or promising companies.
- These stocks also feature low risk due to the fact that such undervaluation is cyclical and the company has the potential to attain its intrinsic value.
Disadvantages of Undervalued Stock
These are –
- Every investor cannot decide to invest in such funds.
- It is time-consuming.
- Investors run the risk of flawed analysis.
Hence, investors should begin by investing in less risky financial instruments when they initially begin. 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.