Undervalued stocks are those stocks that are trading at a price which is assumed to be below its intrinsic value. Some traded prefers investment strategy of picking undervalued stocks as they offer a margin of safety by not being overpriced. World famous investor Late Mr. Benjamin Graham and his apprentice Mr. Warren Buffet always preferred to buy undervalued stocks.
Investors often assume that the cheap stocks are undervalued stocks, but both the concepts are very different. Alone price of the stock cannot be used as a benchmark to determine that share is undervalued or not.
Value investors mainly use below mentioned factors to determine whether the stock is undervalued or not:
- Price-to-Earnings Ratio – By using this ratio, we can compare price of a stock to its earnings and by doing this investor can figure out whether the stock is undervalued or not. For the calculation of the P/E ratio, we divide the market price of a share with EPS (Earning per share) for the past 12 months. For example, if a share is trading at $50 and its EPS for the year were $5, then the P/E will be 10. This simply shows how much investors are willing to pay per dollars in earnings.
Usually, a low P/E ratio indicates the stock is undervalued. For example, a P/E ratio of 15 is much better than a P/E ratio of 35.
- PEG Ratio – PEG ratio means Price-to-earnings ratio. In this, we divide price to its earnings by expected annual EPS growth which will provide another ratio that is used to determine whether the stock is undervalued or not. Majorly value investors prefer PEG ratio over than the simple P/E ratio because of its accounting for future growth. Majorly a PEG below 1 is considered undervalued and above 1 is considered overvalued.
- Book Value per share – Book value is also a common ratio which is used to determine whether a stock is undervalued or not. We can get a Book value by deducting all liabilities with all assets, and then we get a figure. That figure will then get divided by the number of shares outstanding. In this financial ration, investor will compare the book value per share with the stock price and if book value per share is greater than it indicates that share price is undervalued.
The investors may prefer to pick those stocks that are undervalued and buy them in their portfolio whenever their prices are lower than the stock’s intrinsic value. It is majorly believed that the market will improve, and the stock price will jump. Some market participants consider it beneficial to buy undervalued stocks because by doing that they can buy stock of a sound company at a lower price and can reap a higher return in future. Such investors can protect their portfolio from the downside risk of the overvalued holdings.
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