Undervalued stocks are equity shares of a company in the stock market that are selling at a price below their inherent or intrinsic value. Such stocks are undervalued due to several reasons, ranging from geopolitical or socio-economic issues and market downfall.
Why are stocks undervalued or overvalued?
One of the factors that determine stock prices is demand. Moreover, stock prices depend on government policies, social factors and economic and sector growth. But how can you find out the intrinsic value of shares in the stock market today and see if they are undervalued or overvalued?
Here are some financial ratios that can help you to find out the inherent value of stocks:
- P/E Ratio: This ratio establishes a relationship between a company’s stock price and earnings per share (EPS). It brings the real value of shares at proximity and gives investors a better sense of whether a stock is undervalued or overvalued.Formula – P/E ratio = Share price % Earnings per share
For example: If a company’s shares are trading at Rs. 50 per share and its EPS is Rs. 10, then P/E equals 5. This means investors have to invest Rs. 5 per share to yield profits of Re. 1 per share.
You can also compare two stocks’ valuations. Consider two stocks of the same sector, Stock A is trading at Rs. 20 while Stock B at Rs. 10; Stock A seems expensive. Now consider sector P/E ratio is 20 and Stock A P/E ratio is 25, whereas Stock B P/E ratio is 35. This implies Stock A will yield more profits than Stock B per share.
- P/BV Ratio: It is the ratio of the share price at which it’s trading to its price as per its book value. It is used for valuing a company’s stocks and gives a picture of its financial standing and whether it can earn profits in the future.Formula – P/BV ratio = Market price per share % Book value per share
If the P/BV ratio is less than 1, it denotes that the stocks are undervalued stocks.
Know the advantages and disadvantages of undervalued stocks before deciding on stocks to buy today
Advantages of undervalued stocks:
- Undervalued stocks tend to return to their original or intrinsic value
- Investment in undervalued stocks tends to be of low risk since such undervaluation is cyclical and a company has the potential to attain its inherent value
- This investment strategy offers the benefit of buying a stock from a reputed or well-established company at a discounted price
Disadvantages of undervalued stocks:
- Not every investor would be able to calculate the intrinsic value
- Analysing stocks and identifying undervalued ones is a time-consuming process
Should you invest in undervalued stocks?
Undervalued stocks could help you to create substantial wealth in the long term. However, as highlighted before, not all investors can identify such undervalued stocks. If you are one such investor, you could also explore other options and not necessarily stick to undervalued stocks. Whatever the investment strategy, the bottom line is generally wealth creation for many, if not all, investors. In such a case, it is advisable to explore your options under the guidance of a financial advisor, seeking their advice when deciding on the stocks to invest in.