How to Identify Undervalued Stocks
Meaning of Undervalued Stocks
Undervalued stocks are not difficult to spot if you have a fair understanding of stock investing. But for beginner investors, they may not even know what you mean by undervalued stocks. That is why I will like to start this article by explaining what undervalued stocks mean. When a stock is being described as undervalued, it means that the stock is trading below its intrinsic value. That is, the share price is less than how much the stock is actually worth. A good way to explain undervalued stocks is by comparing it with what you usually buy from the market. Imagine someone is offering to sell to you an item that you normally buy at $50 for $30. You will likely jump at the offer. Why? You will like to buy it because you know that the item would have cost you $50 instead of the $30 you are paying. In this case, you can conclude that the item is undervalued. This kind of situation usually occur in stock market too, hence the terms undervalued stocks.
You may then want to ask that why would a stock sell below its intrinsic value. This situation can be caused by different factors. It may not necessarily mean that the company’s performance is totally poor. But when a company fails to measure up to the expectation of the investors, its stocks becomes less attractive thereby forcing the share price to fall. Also, there may be a bad news or rumour about the company. Since the information made available to investors is one of the factors that drive stock prices, people may over-react to negative news. And this will affect the price of such stock. There was a time that a lower court awarded a judgement against a particular bank to pay a substantial amount of money to one of its customers. When the news broke out, the share price of the company took a downward trend thereby making its stock to be grossly undervalued. However, the bank appealed the judgement and the initial judgment was over-ruled. So, this case was totally an over-reaction to negative news. Another reason a stock may be undervalued is when there is a general fall in stock prices especially during stock crash or recession. During such period, people are not attracted to stock market. Instead, you see many people offloading their stocks trying to cut short their losses. When supply is more than demands, prices will definitely fall. So, those are just some of the reasons for having undervalued stocks in the market.
Read Also: Stock Market: Stock Trading Basics for Beginners
How Do You Identify Undervalued Stocks?
Now that you know the meaning of undervalued stocks, you need to know how to spot them among other stocks. If you are looking for undervalued stocks, you need to focus on the following:
- P/E ratio: Price earnings ratio is the current price of a stock divided by its earnings per share (EPS). To get the earnings per share (EPS) of any stock, you will need to divide the earnings of the company by its total outstanding shares. Earnings per share is simply the earnings that is attributable to each unit of shares of a particular company. For instance, if the reported earnings of a company is $1 million while its total outstanding shares is 500,000 shares, its earnings per share will then equal to $2 ($1,000,000/500,000 shares). The significance of price earnings ratio is that, it gives you a fair valuation of a company. So, if you are looking for undervalued stocks, you should focus on stocks with low P/E ratio. This becomes more meaningful when you compare the P/E ratio of a stock with other stocks in the same sector or industry. Price earnings ratio gives you the number of years it will take a company to earn revenue that will be equal to the value of its stocks. The lower, the better.
- Dividend Yield: Dividend yield is dividend per share divided by the current price of the stock. Dividend yield can be described as the returns on investment for individual investors without taking into consideration any increase in the price of the stock. This means that this ratio will only be relevant to dividend paying companies. There are some companies such as growth stocks which may not like to pay dividends. Instead, they will choose to re-invest their earnings to finance their growth and expansion. For such stocks, it may be difficult to use dividend yield to determine whether the stock is undervalued or not. The company may not have good dividend yield. But such stocks may likely enjoy increase in stock price. Apart from using the dividend yield to determine whether a particular stock is undervalued, it is actually a good yardstick for determining high dividend income stocks. High dividend income stocks are good toast for retirees who may need passive income or people who want to supplement their income.
- Price to Book: The price of a stock is just the perceived value that investors place on the stock. Stock price can be influenced by different factors. And this can make a stock to be undervalued or overvalued per time. If you want to truly know the real book value of a stock, you will need to depend on the financial statements of the company. If the price of a stock is too high in relation to its book value, such stock is said to be overvalued. Undervalued stock will usually have its market price lower than its book value.
Read Also: Penny Stocks and How to Profit from Them
Value investors usually like to invest in undervalued stocks. They don’t just rely on technical analysis. They look at the fundamentals of a stocks such as earnings, sales and dividends. Undervalued stocks with good fundamentals are good for investors that intend to hold stocks for a long term. You can use Free Stock Screener to search for undervalued stocks based on the criteria explained above.