In real life, undervalued stocks do form one of the best investment areas in any long-term wealth creation strategy.
From a technical perspective, an undervalued stock is actually one which sells below its intrinsic worth. Meaning that the current market price of the stock is not at par with its real worth.
This could be attributed to some short-term market sentiments or because of some outside short-term factors or even some short-term issues concerning the company. There is a methodology of analytic techniques that will enable investors to identify the actual worth of a company.
In this article, we will examine a few ways that stock can be considered undervalued and highlight important considerations that should be kept in mind ahead of any investment decision.
1. Price-to-Earnings (P/E) Ratio
P/E ratio is one of the most common tools which is used to calculate the estimate of the value of the stock. It calculates the ratio using the following formula:
P/E ratio = Market price of the share / EPS
One aspect or sign that its price may be below its actual value is if it has a lower P/E ratio than its industry peers or the overall market.
A company whose P/E ratio is considerably lower than those of peers in a similar industry may mean that the price of the company is cheaper than it should be.
Conversely, there may be several reasons as to why P/E is low; problems may be embedded in the company.
2. Price-to-Book (P/B) Ratio
It is the net asset value of a company. It is the cost an equity share would fetch with respect to its book value. The P/B ratio is calculated by taking the stock’s price and dividing it by the book value per share as follows:
P/B ratio = Price per Share / Book Value per Share
In case the P/B ratio is below 1, then the stock could be selling at a low price since it’s trading at lower value than the company’s net assets.
This ratio is very useful for the calculation of any capital-intensive business, say bank or manufacturing company where tangible assets hold significant weight.
3. Discounted Cash Flow Analysis
Probably, the most elaborated technique applied to estimate intrinsic value for a business is Discounted Cash Flow, or DCF.
Due to its very name, it is understandable that DCF analysis determines future cash flows developed by the firm and then brings these cash flows to their present values, integrating an acceptable discount rate.
If this current value calculated through DCF analysis is greater than the prevailing market price of the stock, then one could deduce that maybe the stock is undervalued.
Many things are assumed regarding the future of company growth, discount rate, and cash flows. Though it is extremely powerful in terms of determining undervaluation, yet it is limited by its estimation nature.
4. Dividend Yield
For income-oriented investors, dividend yield is just as meaningful of undervaluation. The dividend yield is calculated by dividing annual dividends per share by stock price.
But if it is significantly above average compared with other industries, then this may be an indication that the firm is undervalued, because, for every dollar invested, investors are getting a greater return.
But great care should be exercised in analyzing the sustainability of dividends; the health of the company should be supported in continuation of payments.
5. Relative Valuation through Industry Comparison
This is yet another estimation of undervaluation of a stock that makes use of comparison of valuation metrics of that particular company with peers.
For instance, if the P/E ratio seems to be much lower than its industrial average it probably reflects signs of undervaluation. Everything finds its correct context when placed under sector comparison: one can find outclass opportunities within some sectors.
6. Reading of economic and market sentiment
At times, economics or markets may dictate prices for the short term. For instance, possibly because of some rate of interest due to geopolitical threats, perhaps it is because of a temporary regulatory issue, the price of the stock declines.
At that point, there could be a possibility of undervaluation. An investor would get to know why the share price is falling through the market sentiment and whether that price fall was reasonable or if that was a rare kind of opportunity to buy at a discount.
Conclusion:
Finding under-valued companies is profitable for an investor but does require careful effort.
Using the various metrics which include P/E ratio, P/B ratio, DCF analysis, dividend yield, and relative industry valuation, it becomes possible to decide whether a stock sells below its intrinsic value or not.
However, no metric can guarantee that the stock is under-valued.
It is the combination of these approaches with a broader outlook of market sentiments that will allow investors to make decisions, and may also come across as a source of investment opportunities.
All this entails in reality is a return to basics, patience, and holding an eye on the long-term while value investing is at its very core.