Master Class 13: 3 Ways to pick Undervalued Stocks
Created on 07 Sep 2020
Wraps up in 6 Min
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Updated on 21 Sep 2022
"An intelligent investing is value investing, acquiring more than you are paying for. You must value the business in order to value the stock."
~ Charlie Munger
Indians are mostly known for getting more for less. That is, we try to acquire maximum value from every deal. The bitter truth is that most of us fail to employ that when it comes to stock markets. As an investor, if you are investing in an undervalued stock, you are sure to fetch better returns.
Now, you might be wondering what undervalued stock means. In simple words, any stock that is traded for less than their intrinsic value is called an undervalued stock.
This form of investing is also termed as value investing and was propagated by Benjamin Graham and was popularized by Warren Buffett.
The stock might be undervalued due to a variety of reasons. Hence, a great amount of caution is to be employed while trading in such stocks. There are a few metrics to stick to when purchasing discounted stocks.
How to find undervalued stocks?
Identifying undervalued stocks can be a starting point of building a long-term portfolio. In that case, following a few steps will help you fulfill the task with fewer efforts. Three tools you can utilize to spot an undervalued stock are as follows:
Price to earnings ratio
Price to earnings ratio enables you to find out how much you have to invest in order to get one rupee of the company's earnings in return. It tells you whether the stock is priced rightly, undervalued, or overvalued when compared to its earnings.
Here we compare the share price of the enterprise with its earnings made on equity-based capital. Using price to earnings ratio, you can pick stock which is undervalued currently but might gain momentum in the future. A lower price to earnings ratio signifies that the stock is undervalued and might churn higher earnings per share.
For example: Say stock A is having a market price of Rs. 50. It has an EPS of 5. Thus, the stock will have a P/E ratio of 10. Hence, as an investor, I should pay a sum of Rs. 50 in order to earn Rs. 5. On the other hand, stock B has an EPS of 2 and has a P/E ratio of 25. So you will obviously invest in stock A.
Price to book ratio
Price to book ratio compares the market price and book value in order to find out its real market valuation. Just like the P/E ratio, another important parameter to purchase discounted stocks is the P/B ratio or price to book ratio. This ratio is calculated by dividing the market price of a share by its book value. Any stock whose market price is lesser than the book value can be classified as an undervalued stock.
In short, a P/B ratio of less than 1 can be a denotation of discounted stock. Here, the market undervalues the company's real value by failing to consider the value of its tangible and intangible assets.
Supposedly, a Fashion and Retail company has assets that are worth more than its main line of business. But the market might skip this fact and undervalue its assets.
Net cash flow and a dividend yield
Net cash flow is the money left after paying off all business or operating expenses. While a lot of investors pay attention to net profit, net cash flow should also be given importance to. Because a company can use its net cash flow to meet its debt obligations, make new investments, innovate its products, offer one-time dividends, etc.
A company that has a history of strong financials and a good dividend yield is always an attractive investment pick. Therefore, a company that maintains consistency in dividend payout despite a low stock price translates that the enterprise is financially stable.
So, always look out for companies with good dividend yield and net cash flow. However, exercise caution while checking the dividend yield. Ensure that the company does not pay its entire earnings as dividends. Because, in such a situation, the company may not be making any possible investments, which could have been made using the profits.
Have you read our previous Master Class: Understanding Quick Ratio & Interest Coverage Ratio ?
What can best bring out the difference between two stocks than a comparative analysis! Always compare an underperforming stock with its peers. Find out what has gone wrong with the stock that has undervalued it. As mentioned earlier, a stock might be undervalued due to reasons like an economic slowdown or some other crisis. The stocks of the company's peers or competitors might also be overvalued sometimes. If the company has been there for quite some time, ensure that you check how it had performed during the last crisis or recession to get an idea of its capability.
Important things to take note while Finding Undervalued Stocks:
A few other important things to take into consideration while choosing undervalued stocks are,
- The earnings history of the company. A company that is making steady progress even if it is slow is a good sign.
- When a company hasn't indulged in any corporate governance issues or scams, it expresses its reliability.
- While conducting an analysis of the stock, it is always recommended to read through the business model, revenue model, and various other important key documents in order to pick out any red flags.
- It is always beneficial to invest in a company that has enormous potential to grow in the future. A company that has an innovative or unique line of products with an ability to create a change is always worth investing in. For example: if you had identified the true potential of Infosys a few years back, I am pretty sure you would have reaped some good profits.
- Take the various credit ratings into account as well.
- See the PEG ratio of the company. A low PEG simply means a good growth possibility.
- The current ratio will help you in figuring the answer to the question, "is the company capable of meeting its debt obligations?"
- ROCE, ROE, and debt to equity are a few other ratios you will want to look before investing.
Invest in Holding Company to find Undervalued Stocks
Another unique way of investing in high priced stocks is by indirectly investing in them. This is a useful tool through which you can take advantage of undervalued stock and invest in costly ones. So how do you do it?
Let's take a look at the following example:
Take the case of Godrej industries. The company holds a share in Godrej consumer products, Godrej Properties, and Godrej Agrovet. Hence, by investing in Godrej industries, I am indirectly investing in all these stocks at a price lesser than the price of all the three stocks.
The identification is a crucial process and involves a lot of calculations and considerations. Stock identification is an important step of investing, and every potential investor must understand how to spot the right stocks by categorizing them under rightly valued, overvalued, or undervalued.
The above tips and information might help you in locating the right stocks. If you are still facing certain issues, then you can simply go to Ticker. Here you will find a list of stocks with which you can start your investing journey.
Also, watch this in order to acquire a better understanding: YouTube. And never fail to remember that you are sure to reap the benefits whenever you place your bet on a perfectly analyzed stock. So what are you waiting for?
Checkout the next series of the blog: How to Analyze Company's Profit and Loss Statement
To read all Master Class series: Click Here
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