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The term ‘undervalue’ signifies that something has a price lower than its real worth. When this term is used for stocks, it gives an idea that the stock is trading at a lower price than it should be. Thus, they are called undervalued stocks.

What Does ‘Value’ Mean in Stocks?

Everything you purchase will have a price and a value, and stock is no exception. Price is an amount attached to a stock based on its demand and supply, whereas value is something you assign to a stock after assessing its benefits. 

The stock price would be the same for every investor; however, the stock’s value could be different. From there comes a concept of the fair value of the stock.

The fair value or intrinsic value of a stock is the value you attach to the stock after considering the fundamentals and financials of the respective company. The market price of a stock can be below, above or equal to the fair value. 

You can compare the stock’s price with its fair value to decide whether it is undervalued or overvalued and make investment decisions accordingly.

What are Undervalued Stocks?

Undervalued stocks are those stocks which seem to trade at lower market prices than their fair value. A stock may seem undervalued when the potential benefits it can offer are more than what you need to pay for it now. 

There are multiple reasons which may lead the stock to be undervalued. For instance, if the overall market faces adverse conditions, the stock may start trading below its intrinsic value. If any rumours or bad news about the company comes out, its price may fall even if there are no fundamental changes. 

However, if you can identify undervalued stocks, you are in a better position to earn significant investment returns when they reach their fair value or go above it. The simple idea is to find undervalued stocks before the market. 

Here are some ways which may help you do so.

How to Find Undervalued Stocks?

Analyse ratios

Here are some ratios which may help you identify undervalued stocks.

Price-to-earnings ratio

Price-to-earnings (P/E) ratio is one of the popular metrics used to identify undervalued stocks. The lower P/E ratio may suggest that stocks are undervalued as their current market prices are lower than what fundamentals suggest. Conversely, the higher P/E ratio may indicate overvalued stocks.

The formula for the P/E ratio is as below.

P/E ratio = The current market price per share / Earnings per share (EPS)

EPS = Company’s net income / Total outstanding shares

For example, XYZ stock is traded at ₹40. The company’s net income is ₹2,00,000, and it has a total of 20,000 outstanding shares. It means EPS is ₹10. Therefore,

P/E ratio = ₹40 / ₹10 = ₹4

The resultant amount is what you need to pay per share for ₹1 of a company’s earnings.

Here the PE ratio of ₹4 means that for every ₹1 of a company’s earnings you are paying ₹4.

Learn: Earnings Per Share (EPS)

Price-to-book ratio

The price-to-book ratio measures how much you need to pay per share relative to its book value. A lower P/B ratio suggests that the stock is undervalued as you would have to pay a lower price per rupee of the book value of a share. On the other hand, a higher P/B ratio would signal overvalued stocks. 

Here is the formula for the P/B ratio.

P/B ratio = The current market price per share/ Book value per share

You can calculate book value per share by the following formula:

Book value per share = (Assets – Liabilities) / Total outstanding shares

For instance, if the market price of ABC’s stock is ₹150 and the book value per share is ₹100, then, 

P/B ratio = ₹150/₹100 = ₹1.5

This means you need to pay ₹1.5 per share for ₹1 of book value per share. 

Dividend yield

A dividend means a part of the profit the company pays shareholders as a reward, and the dividend yield is the dividend as a percentage of the stock’s market price. Investors aiming to earn regular income from their investments generally look for stocks offering higher dividend yields than those offering lower.

Here is the formula for dividend yield:

Dividend yield = Annual dividend per share / The current market price per share

Suppose a company, the stock of which is traded at ₹100, pays an annual dividend of ₹10 per share, then, 

Dividend yield = ₹100/₹10 =10%

Return on equity

Return on equity (ROE)  is a crucial metric that tells you how much profit the company is making from the capital received from equity shareholders. If a stock offers higher ROE and yet is traded at a lower market price, it may be an undervalued stock. If the ROE generated by the stock is lower but is traded at a higher market price, it may be an overvalued stock. 

Here is the formula for ROE:

ROE = Net income / Shareholders’ equity

Shareholders’ equity = Total assets – Total liabilities

For instance, if a company recorded a net profit of ₹1,20,000 and has a shareholder’s equity of ₹6,00,000, then,

ROE = ₹1,20,000 / ₹6,00,00 = 20%

Compare the stock price with industry peers

Another way to help you identify an undervalued stock is by comparing the stock price of companies in the same or similar industries and at the same life cycle stage. 

Let’s understand by an example. 

Companies from the FMCG industryLife cycle stageStock price

Company A may have an undervalued stock from the companies in the growing stage. However, consider the following before making an investment decision.

  • Check whether company C is correctly valued.
  • Assess the reason for company A’s lower market price.

Study the cash flow

You may also consider looking at the free cash flow (FCF) to decide whether the stock is undervalued. FCF is the cash flow remaining after paying operating expenses and capital expenditures. If the FCF of the company is increasing, it may be a green signal.

Who Should Invest in Undervalued Stocks?

Investing in stocks can be time-consuming, and you’ll need to pay close attention to market movements. Therefore, those with a good understanding of fundamental analysis and a basic idea of technical analysis may be able to identify undervalued stocks. Plus, investors who have the patience to stay invested for a longer term may find it beneficial to invest in such stocks as it is a time-consuming process. 

Moreover, different investors have different risk tolerance levels. Risk-averse investors may find undervalued stocks less suitable as the lower market price tends to result from lower demands and lower confidence of investors toward them. Plus, whether such stocks would reach their fair value is uncertain and yet may prove to be a risky investment. 

On the other hand, risk-seeking investors may look for such stocks to earn significant investment returns against higher risk. However, investing in stocks requires knowledge and time to identify the right stocks. Also, you need to keep track of their performance and monitor them regularly.

What is the Best Way to Invest in Undervalued Stocks?

If you attempt to identify undervalued stocks and invest in them, you are said to use a value investing strategy. However, investing in a few such stocks may increase risk as your investment returns depend on those few stocks only. A better option you can consider is investing in value funds.

Value funds are those mutual funds which primarily invest in undervalued stocks. They tend to invest in undervalued stocks across various sectors and locations, reducing the overall risk. Plus, the fund managers perform fundamental analysis before selecting stocks which may increase investment decisions’ accuracy. 

Things to Consider Before Investing in Undervalued Stocks

  • You may come across hot tips stating some stocks as undervalued ones, but do not blindly follow them. Instead, do your own research.
  • If you find any stock undervalued, go deeper into why it is so, and make investment decisions accordingly.
  • Even if you find stocks at a discounted price, it is better to adhere to your investment objective.

Explore: Value Stocks vs Growth Stocks

Advantages of Investing in Undervalued Stocks

  • Potential to get greater investment returns: One of the biggest benefits of investing in undervalued stocks is that you get a chance to buy them when they are priced below their value. This way, you would enjoy greater investment returns when the market would realise their true worth. 
  • Lower risk of significant loss of capital: You are less likely to have a significant loss if you buy stocks when their prices are considerably lower than their intrinsic value. Holding them for longer may further reduce the risk if they grow steadily.

Disadvantages of Investing in Undervalued Stocks

  • Difficult to identify: You need to compare the market prices of stocks with their intrinsic values, and there is no one exact way to find intrinsic value. Therefore, the stocks you find undervalued are the ones you believe to be so, which may or may not be true.
  • Time-consuming: Identifying undervalued stocks requires thorough research of all related aspects, which may take considerable time.
  • Chances of falling for the value trap: Not all undervalued stocks would give significant investment returns as there is no certainty that they will reach their fair value. You may end up making a poor investment decision in the hunt for cheaper stocks.

Learn: ESOP vs RSU