Four key reasons why a stock is undervalued

Highlights

  • Undervalued shares are referred to as those stocks that are traded at a lower market value than their intrinsic value.
  • The phenomenon is directly opposite to what happens in case of overvalued shares.
  • Overvaluation of a stock occurs when its market value is higher than its intrinsic value.

Undervalued shares are referred to as those stocks that are traded at a lower market value than their intrinsic value. The phenomenon is directly opposite to what happens in case of overvalued shares. Overvaluation of a stock occurs when its market value is higher than its intrinsic value.

The intrinsic value of a share depends on the company’s fundamentals. This value can be evaluated using financial statements, cash flow, profits, management of capital, and returns on assets.

Four key reasons why a stock is undervalued

Generally, investors employ value investing to determine if a stock is undervalued or overvalued. Traders purchase undervalued shares at low prices with a belief that the accurate worth of the stock would be realised going forward. There are several reasons for a stock being undervalued.

Here we discuss the four factors that determine the undervaluation of shares.

Weak stock market conditions

A weak market scenario is generally considered as the foremost reason to explain the undervaluation of shares. There are times when the overall market sees a crash due to reasons, including herd mentality and overinvestment, rendering several stocks undervalued. Thus, investors should be aware of ongoing market conditions to determine the share valuation.

Cyclical behaviour

Cyclical behaviour also plays a key role. The seasonal nature of a business or the company’s production and sales also define the profits garnered by it. A low demand for the company’s products or services can reflect in the form of weakness of its shares. Even if a company boasts strong fundamentals, the stock price is bound to get undervalued during a decline in its sales. However, a stock market works in a cyclical manner. The undervalued stocks with strong fundamentals generally rise again when the company’s profits rise. 

Overvaluation of a stock occurs when its market value is higher than its intrinsic value.

Source: © Herrbullermann  | Megapixl.com

P/E ratio

The PE ratio tells how investors think the company is performing or how much they are willing to pay for US$1 of earnings. Generally, a stock with a PE ratio below the industry average is considered undervalued. Low P/E generally translates more profits against the price paid for the share. Value investors closely look at firms with low P/E ratios to maximise their profits.

P/B ratio

P/B ratio is the ratio between the firm’s book value and the price per share. It reflects the company’s financial strength. Low market value, compared to the book value, is the mark of the best undervalued stocks.

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