How To Identify Undervalued Stocks

Undervalued and Overvalued stocks are the integral part of fundamental analysis. It is essential for the investors who are interested in learning fundamental analysis & also want to become profitable investors/trader to understand that, to trade is a life-long journey. There are many ways to identify undervalued stocks for long-term investment, some of are described as below:

A stock can be considered as undervalued when the price at which it is currently trading in the market is below the intrinsic value that it has. To put some more perspective upon it, I would say that a valuation is the price which a typical investor is willing to pay to buy a company given the way it runs its business. Hence in other words we can say that the value stocks generally trade at bargain as compared to their book values.

Value stocks generally have a high dividend yield because they trade at a price which is at a discount to the price which can be attributed to the stock considering its fundamentals such as revenues, earnings, cash flows, financial ratios, etc. So, in order to conclude that whether a stock is undervalued or overvalued, we must first arrive at some approximate valuation. I used the word “approximate valuation”, as there can’t be a correct valuation for any stock since valuation inherently involves a lot of forecasting into numerous fundamental parameters. Hence in order to arrive at this valuation we have got three basic approaches - the first one being the Asset based approach, the second one being the Income approach and the third and most prevalently used approach is the market-based valuation approach.

In case of Asset based approach, the fair values of liabilities are reduced from the fair values of asset to arrive at the net worth of the company. This provides the lowest valuation & generally used in cases to arrive at the liquidation value.

Under the Income approach, DCF is the most favoured method which involves discounting the forecasted free cash flows of a firm at discount rate (Kc) which is the cost of capital. The value arrived is known as enterprise value from which the market value of net debt is reduced to arrive at the market value of equity.

Now the most popular one is the market-based approach – “Relative valuation”. As the name describes itself, this method doesn’t lead to an absolute valuation. Rather it aids in arriving at a valuation metrics which help an investor to compare the company in terms of its peers. This helps in arriving at a conclusion that whether the subject company is overpriced or trading cheap in comparison with its peers or the concerned industry. The Price to Earnings ratio, popularly known as the P/E ratio is the most widely used relative valuation metric when it comes to retail investor or for a layman. A P/E ratio basically describes what price an investor is willing to pay for every $ earned by the company.

A high P/E typically says that the stock is overpriced while a low one says that the stock is trading at a discount. However, the same is not always true given that the markets are not just about the P/E’s it also considers forecasted growth as a very important aspect in the valuation. Thus, a high P/E indicates that the investors see a lot of growth potential into the stock going forward and expects a lower amount of overall risk. One of the examples of such a company is Amazon trading at an exorbitant P/E of 249.69 times. On the other side a lower P/E may indicate that given the fundamentals of the company, the price is trading lower on account of various temporary factors such as any corporate governance issue, change in management, quarterly earnings coming below the market expectations, etc. Hence through this mechanism an investor is enabled to identify the mispricing prevailing in that particular stock and then has to wait for a catalyst to occur, so that the stock achieves its fair valuation & the investor reaps the underlying benefits. The inherent risk in investing in such undervalued stocks is that they might never achieve their fair valuation.

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