Overview

Undervaluation of stocks refers to a situation wherein the shares or other securities of a company are traded at a lower market value than what their intrinsic value warrants. The intrinsic value of the stocks is based on the company’s fundamentals and can be assessed using financial statements, cash flow, profits, management of capital, and returns on assets.

Undervaluation is in direct contrast to overvaluation of shares. Overvaluation occurs when the market price of shares is higher than the perceived intrinsic value.

Investors’ belief that stocks are undervalued is purely conjecture based on an analysis of the company’s fundamentals and other factors determining its performance. This is generally a subjective opinion and investors may often not be able to pinpoint the amount by which a share is undervalued.

Value investing

Using the strategy of value investing, traders tend to buy the most undervalued shares at low prices now. They believe that the accurate worth of the stock will be realised in the future and investors will scramble to buy the shares even at a higher price. Often investors who resort to value investing as their primary methodology refrain from purchasing securities that are overvalued in the market, and hence will yield lower returns.

Reasons

When an investor conducts research and analysis to determine the intrinsic value of companies’ shares to decide which securities they will purchase, they consider a range of variables. It is these variables that dictate the valuation of shares.

Before you take a call on whether value investing is the right strategy for you, take into consideration the factors that determine the undervaluation of shares.

The overall market is down

Perhaps the most common factor resulting in undervaluation of shares, the market as a whole suffers when the macroeconomic conditions of a country are poor. The value of a number of shares comes down with the market due to these adverse conditions. Investors should have a basic understanding and awareness of the economic conditions in order to determine the valuation of shares. Sometimes, the market can crash due to investor behaviour such as herd mentality and overinvestment, rendering several stocks undervalued.

Diversification

Businesses that are able to find disruptive products and services, new markets, positioning or even channels, can have undervalued stocks. Brands that have traditionally been associated with a particular product or service may branch out in fresh directions, or take advantage of situations conducive to a new approach, are priced at the same market value despite these innovations. A shrewd investor, however, will pick up on this in a timely manner and purchase such undervalued shares.

Cyclical behaviour

Profits define the valuation of a company’s shares. Often, they can be cyclical based on the seasonal nature of a company’s production and sales. Moreover, the demand for its products or services can be felt in a cyclical pattern. So, even if such a firm has strong fundamentals, the price of its stock will become undervalued during a dip in its sales, only to rise again when its profits rise. Traders who can recognise this can make good u3e of value investment.

Herd mentality

It is advised that investors adhere to the momentum in which the market pendulates when they are placing trades, and taking decisions on the sale or purchase of assets. When the general momentum of the market is high, investors line up to buy shares, and, conversely, sell them when it declines because of herd mentality. Because of this, the shares become undervalued. So, to reap the benefits of valuation trading, investors should hold on to such shares.

Non-trendy stocks

The demand for stocks of companies that are leaders in trending sectors tend to attract more investments. Meanwhile, well-established firms in sectors that may not be fashionable but have robust fundamentals can go undervalued. Investors should be aware of various sectors and willing to diversify in order to make the most of valuation trading.

Bad press

When a company gets caught in a situation that leads to negative media coverage, the price of its stocks always falls. However, such bad press is just one of the many setbacks a business has to face and overcome. The damage to share value due to such coverage can just be temporary and not an indication of its complete downfall. When such an incident occurs, traders must assess whether the company is strong enough to tide over the crisis, and they can then invest in its undervalued stocks to make bigger profits in the future.

Low price-to-earnings ratio (P/E ratio)

A company’s price to earnings ratio reveals the share price relative to the portion of earnings due to that share from the equity capital raised by the company. A high P/E ratio means that the price of the stock will be more when compared to the profits made from it. Low P/E, on the other hand, translates to more profits against the price paid for the share. Value investors should watch out for companies with low P/E ratio to maximise their profits.

Price-to-book ratio (P/B ratio)

The price-to-book ratio is the ratio between the company’s book value and the price per share. It is a metric of the company’s financial strength and indicates whether the company can make profits in the future. Low market value, when compared to the book value, is the mark of best undervalued stocks, unless the company is facing a severe financial crisis.

Net cash flow

Usually, companies are judged as good investments if their reported profits are big. However, some investors focus more on the company’s net cash flow. Net cash flow refers to the cash flow remaining after all outflows such as capital and operating expenses have been adjusted. Stocks with good net cash flow can but lower earnings can be priced low. However, they can become a good deal in the long run if the company uses this cash to expand operations, thereby driving up its share price.

High dividend yield

A company pays out high dividends when it does not have more opportunities to invest. For this reason, the share price of the company may fall. This may be alarming for some investors, but it can also be a signal to investors that the funds available for dividend payout can help the company weather adverse market conditions. If other factors show that the company is in no imminent financial danger, investors can buy this stock and earn some dividends now. They can also sell the shares when the price rises on a future date.

Low-debt stocks

Low debt is obviously a desirable trait in stocks, irrespective of whether you are a valuation trader or not. Power, steel and infrastructure companies often have very high debts, making investment averse to value traders. Companies with low debt and steady growth that can be seen in terms of profits often carry undervalued stocks. The prices of such stocks are bound to rise in the future.

Conclusion

Traders looking to make long-term investments, or those who can wait patiently for undervalued stocks to rise, must go for such an investment approach. While this is not an exhaustive list and none of the factors mentioned above is enough to confirm whether a particular stock is undervalued, viewed together, they can present a clearer picture of a firm’s share valuation.