If the investor’s mantra is buy low and sell high, when markets fall there are bargains to be had.
Of course, you can play it safe and invest in a huge company or brand, such Apple or Microsoft. But even when they are off their peak, they remain highly prized and expensive.
A better alternative is to find cheap stocks with great potential. These are known as undervalued stocks, and the key is to recognise them, understand fully why they might be undervalued and seize profitable opportunities before prices start surging.
Here we explain the basics of finding undervalued stocks:
What are undervalued stocks?
An undervalued stock is one that has a market value beneath its true worth. Market value is what somebody is willing to pay for a stock, and this can be impacted by hype, legal issues or anything else that negatively affects the company’s standing.
If a company’s reputation falls, so can its market value. However, the true, or fair, value of the company’s assets and core business can remain the same. When this happens a stock can be considered undervalued.
If you can identify a stock that is worth more than its market value, you can invest in it and wait for its price to catch up to its fair value, and make a profit along the way.
Why do stocks become undervalued?
There are plenty of reasons why a stock can become undervalued. Perhaps the company in question is not popular or lacks exposure, but still performs well and forecasts good growth.
Such firms can see growth in sales and profits as they travel from one quarter into another, but their stock prices lag behind, as the firms go unnoticed by investors and traders.
Alternatively, perhaps a firm gets some negative press, which causes traders to lose faith in it and oversell its stock. In this case, the stock price will drop due to greater supply and lower demand. However, the negative press might not damage the company enough for it to go out of business. If this happens, you end up with a still quite successful firm with a cheap stock.
And sometimes, as in the present bear market, it’s just a slumping market that takes a company’s stock down. In any event, the result is the same: a good company ends up with cheap stocks that you can buy and sell at a profit when markets rebound.
The key is that you cannot just find any cheap stock and assume that it is undervalued. Sometimes, a cheap stock is just a cheap stock, and its fair value is equal to its market value. To benefit, you need to ensure that the stocks you buy — and the companies themselves — are of good quality and have potential.
How do you identify undervalued stocks?
Unfortunately, the simple answer is not that simple: lots of research. However, the first step of that research is to learn what to look for.
There are two things that traders do to find undervalued stocks, or to predict the price movement of stocks before investing in them. This is done regardless of the type of stock. Whether it’s a successful stock or an undervalued one, the research methods are the same:
- Fundamental analysis
- Technical analysis
Fundamental analysis is a method of evaluating the value of assets through the study of external influences, such as the broader economy, as well as the company’s basic fundamentals: its management and financial statements.
Technical analysis is a way to determine the stock’s value and potential by examining its historical data. This means looking at statistics that show how the stock has performed throughout the company’s history.
Such data can show you annual trends in price. For example, if a company sees a lot of sales during the summer holidays, then investing in it near the year’s end could be the best way to make a profit. If the same stock tends to drop just before winter, then that could be an indicator of when to sell.
Basically, fundamental analysis shows you the reason why the firm’s stock might rise, while technical analysis is there to reveal how the firm has performed in the past. Together they are great tools to use to find undervalued stocks.
Identifying undervalued stocks: primary ratios
Several primary ratios form part of the fundamental analysis that you need to consider alongside your technical analysis. These ratios can, and will, vary based on the industry or sector in which the company operates. However, you can still use them to your advantage.
Price-to-earnings (P/E) ratio
A company’s P/E ratio is the most popular way to compare the value of the firm with its stock to see if it corresponds to fair value.
The ratio shows how much you have to spend in order to make a $1 profit. First calculate the firm’s earnings per share, which you do by finding the firm’s total profit and then dividing it by the number of issued shares.
Then calculate the ratio by dividing the price of the share by the earnings of the share. If the ratio is low, then the stocks are undervalued.
Price-to-book (P/B) ratio
The P/B ratio allows you to assess a firm’s current market price against its book value. It’s a pretty simple calculation that you perform by dividing the market price per share by the book value per share. If you end up with a result that is below one, then the stock is most likely undervalued.
Dividend yield compares the firm’s yearly dividends with its stock price. Simply divide the annual dividend by the price of a single share. The greater the ratio, the greater your returns on your investment should be. However it’s worth remembering that a falling stock price can adversely affect the dividend yield ratio.
Return on equity (ROE)
ROE is another way to measure a firm’s profitability. The calculation is simple: just divide the firm’s net income by its shareholder equity. If the percentage is high, that means that the firm is generating a strong, high income compared to the amount of shareholder investment. Therefore, the shares are undervalued, and you should consider investing in them.
Debt-equity (D/E) ratio
Once again, we rely on equity, only this time it’s the firm’s debt against its assets. If the ratio is high, it’s a sign that the company is highly leveraged, which can be cause for concern.
However, it’s important to note that this does not necessarily mean that the stock is undervalued. Similar firms within an industry tend to carry the same debt levels. So for a clearer picture, it’s worth comparing a company’s D/E ratio with that of its competitors.
Earnings yield is the same as P/E ratio, only in reverse: divide earnings per share by the price. It’s a simple tool to use when comparing the return on your investment with less risky assets, such as bonds, or term deposits, which give a fixed return.
This represents the firm’s ability to pay its debts. It is yet another simple calculation: just divide assets by liabilities. If the ratio is lower than one, it usually indicates that the firm cannot cover its debts with its assets. The lower the ratio, the greater the chance that firm’s stock price will keep sinking. However, if the sinking continues, at some point the stock could become undervalued!
Price-earnings to growth (PEG) ratio
This compares a company’s P/E ratio with the company’s growth over a set time frame. It can be used to estimate the firm’s future growth, and whether the stock is undervalued.
Investing in undervalued shares is a great way to maximise potential profits. However, making proper assessments are the key to earning profits rather than losses. So use as many methods to check a company’s track record as possible. With proper research and a few ratio calculations, you can make educated investment decisions, and not gamble your financial wellbeing on luck.
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