An undervalued stock is one whose price is lower than its true or “fair” value. Undervalued stocks may be priced below their fair value due to many factors such as market crash, lack of corporate recognition, negative news, etc. Regular stock market investors who conduct fundamental analysis while making stock selection would know that the main premise of this analysis is that market prices will adjust over time to reflect an asset’s “fair” value and this will eventually result in profits.
In many cases, and for various reasons, a stock’s market price is not necessarily a reflection of the company’s present value. Smaller companies, for instance, that are often ignored by analysts and investors, may experience an increase in their sales and profits, but this will not necessarily be seen in their stock prices.
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Here, we will discuss some of the top ways in which an investor can identify undervalued stocks in India.
Understanding undervalued stocks: an overview
An undervalued stock is a stock that is trading for less than its intrinsic value. Intrinsic value is the value of a stock based on its underlying fundamentals, such as its earnings, assets, and management. Undervalued stocks can be a good investment because they have the potential to rise in price as they approach their intrinsic value.
Screening tools and resources for identifying undervalued stocks
Here are the top techniques that you can use to identify an undervalued stock:
Stock’s current ratio
To understand how a current ratio can identify an undervalued stock, one must first know the ideal current ratio in a given scenario.
Current Ratio = Current assets / Current liabilities
Experts suggest that a healthy current ratio is around 1.25 and if it is in the range of 1.75 to 2.25, it is an indication that the company may have a huge potential to reduce its working capital allocation and place the available capital in other productive areas. To identify an undervalued stock, one must use this ratio very cautiously while looking at the different components of the ratio.
Innovative business model
Innovative businesses can not only find new products to cater to the market but also find a new market altogether, or even a new positioning model. An example from the 1990s is how Infosys set a new benchmark of innovation in the global IT space by offering high-end solutions supported by a weak currency and a positive tax outlook. The company managed to create wealth for itself and also for the entire IT industry in India. Identifying such companies and investing in their stocks can make for a profitable long-term investment.
Debt leverage of the stock
High debt stocks are known to create little value, as seen in the case of infrastructure, power, and also steel stocks. The performance trends of these stocks have often given reflected negative or deeply negative returns. An undervalued company will have low debt and steady revenue growth.
Sudden growth in earnings
This is one of the best indicators of a stock experiencing turn around. The stock market is always looking for such stocks and willing to pay a premium, especially where the earnings are expected to grow at a very fast pace.
Price/Earnings to growth ratio
This ratio connects the PE and earnings growth of a company to check for under or overvaluation of its stock. It takes into account a company’s current and future earnings growth rate to estimate its potential. If the PEG ratio is low, it indicates an undervalued stock that carries a high potential for growth.
ROE and ROCE against industry average
ROE or return on equity and ROCE or return on capital employed are two key ratios that help to measure the returns that equity and debt stakeholders can expect, respectively. If both these ratios are higher, it can drive a company’s growth alongside the P/E ratio of its stock.
Stocks with low cost of debt
While overall debt makes for one side of the coin, the other side features the cost of debt. If a company’s cost of debt is seen to be coming down consistently or if the company’s interest coverage is seeing a consistent and sharp rise, then it indicates that the company’s stock is undervalued.
Free cash flow
Free cash flow (FCF) is the cash generated from the main business and that remains with a company after covering all its expenditures. Cash flow can offer an insight into the company’s ability to cover its operations and capital expenditures. Cash flows are also used by companies to pay dividends and offer share buybacks.
Many investors use cash flow as a value metric. A common indication of an undervalued share that has future growth potential is if a company’s stocks are trading at a lower value while its cash flow is rising.
Conclusion
Although the above indicators can help investors identify undervalued stocks, it is advisable to read through the company’s business model, operating and revenue model, and look for other critical information for any potential red flags. One should avoid using a single measure to determine a stock’s potential and instead focus on a holistic view of the company’s financials.
FAQs
A higher P/E ratio indicates that investors are willing to pay a higher price for a stock as they expect it to attain higher growth in the future. For good investment opportunities, investors prefer P/E below 20 since it reflects an attractive growth potential.
The food industry is known to be one of the fastest growing sectors in India. The country boasts of a strong processed food manufacturing presence which contributes heavily to the industry’s growth.
A stock is said to be overvalued when the market separates its price from the fundamentals. Buying an overvalued stock will probably result in underperformance, as the price could fall back to its real value in the long run.
The price to book ratio is a comparison of a company’s current market value to its book value. If, for instance, a company has assets that are worth more than its profits from primary operations, its stock could be undervalued even if it has strong financials. Price to book ratio helps investors to look at the company’s assets and liabilities in a holistic manner.
Yes, management changes of a company can impact its stock price. However, such changes often take longer to reflect on the stock price and therefore, some stocks could remain undervalued for some period.
