Understanding undervalued stocks and where to find them

Highlights

• Investors often hunt for undervalued stocks. This approach is known as value investing
• Undervalued stocks can minimize exposure to fluctuation to a certain extent.
• Not all stocks with low price-to-earnings (P/E) ratios are quality undervalued stocks.

Paying C$ 50 for a thing that actually has a higher worth, say C$ 70, can be a bargain deal. Likewise, in the equity investment world, investors often hunt for such undervalued stocks, and this approach is known as value investing.

However, spotting quality undervalued stocks can be a tricky job.

Also read: 8 reasons why you can save your retirement income in TFSA

Firstly, one should clearly understand that ‘undervalued’ does not necessarily mean cheap. The former are stocks that are trading at a lesser value at the current price levels than their actual value.

Let’s discuss the aspects of undervalued stocks, including why they are considered undervalued, whether they are worth exploring and how you can smartly spot them.

Why are stocks undervalued?

There could be many reasons triggering this drop in value, such as:

Company-specific 

Company-specific reasons can be quarterly financial results, merger and acquisition (M&A) news, expansion plans, etc., that could trigger any positive or negative movement in any stock prices. For instance, stocks of e-commerce infrastructure firm Shopify Inc (TSX: SHOP) dropped by over 14 per cent on May 5 after the release its Q1 FY2022 results.

In the case of undervalued stocks, missed analyst expectations in quarterly results, competition, legal issues against the company, etc., could result in freefall.

But some of these factors, like financial performance, can improve with time depending on the company’s ability. Value investors can analyze the severity of the cause and ensure that the underlying business of a stock is robust enough to rebound in the long term.

Sector-specific 

Some sectors are cyclical in nature and hence, more vulnerable to the market cycle than other sectors. During the downtrend phase of the market cycle, companies in these sectors could witness their stock prices fall, even to record lows, despite robust business and fundamentals.

Should you explore undervalued stocks?

Quality stocks that are trading at discounted values can minimize exposure to fluctuation to a certain extent, especially during market correction. A theoretical argument behind this is that undervalued stocks are already trading below their true value in contrast to overvalued stocks, which can plummet to their intrinsic value.

Furthermore, such stocks could have a less negative impact and may even outperform growth stocks in weak market environment, which can help you prepare for economic downturns.

Also read: How to handle a bearish phase in the market?

How can you spot quality undervalued stocks?

Not all stocks with low price-to-earnings (P/E) ratios are quality undervalued stocks. Key metrics like return on equity (ROE), debt-to-equity (D/E) ratio, and current ratio can collectively help assess a stock’s health.

Additionally, investors should check financial and operational results to ensure that the underlying business and its future outlook are strong. These details will help investors assess a stock’s intrinsic value and help evaluate if it could potentially grow higher to that value in the near or long term.