What Are Undervalued Stocks?

During the festive season you spot your favourite brand’s shirt on sale, the one that was available for Rs.3500 is now available for Rs.2000 in sale. A normal human tendency would be to grab this extraordinary deal because you are getting the same shirt, same quality just the price is temporarily low due to the festive sale. 

The stock market also has such deals, where some stocks of great companies are sold for a lesser value as compared to their actual worth. These types of stocks are known as undervalued stocks. 

The art of finding these undervalued or bargained stocks is called value investing.This strategy of buying undervalued stocks is not a getting quickly rich scheme, rather it is a patient way and a smart strategy for long-term investing tips.

If you are a beginner in the stock market you should  learn how to identify undervalued stocks, especially those with a low P/E ratio, which can make a huge difference. Let’s look at it in this informative blog.

What Are Undervalued Stocks?

In the stock market the price of stock is different from the value of the stock. Price is what you pay for a share in the stock market, which changes every second and value is the company’s real worth based on factors like financial health, profits and future potential. 

An undervalued stock is simply a stock whose market price is way below its true value. A value investor searches these stocks, buys them, and waits for the market to rise back, due to this rise the price goes up and the investors earns the profits. 

A low stock price is not considered as a good deal always, as a Rs.10 stock might seem cheap at the moment, but a falling stock is not the bargain; it’s just a bad investment. It is also known as value trap, these cheap looking prices are just traps because the company might have serious fundamental issues in its functioning.  

Features	Undervalued Stocks	Value Trap
The Company	A strong, profitable business with a bright future.	A weak business that’s losing money or is in a dying industry.
Reason for Low Price	A temporary setback, market panic over some news, or the whole industry is just suffering.	Deep-rooted problems like too much debt, bad management, or unwanted product range .
Future Outlook	Likely to bounce back and grow.	Likely to get worse. The stock is cheap for a reason.
Investor’s Goal	Buy a great company at a discount.	Avoid a failing company, no matter how low the price is.

Read Also: 10 Most Undervalued Stocks in India

How to Find Undervalued Stocks

To look for an undervalued stock the investors need to first do the fundamental analysis of the company as well as the stock. Fundamental analysis consists of analysing the company’s financial health to check the stocks true worth. One can use websites like moneycontrol and screener.in to access the data and then make rational decisions. You should consider the following to judge the company’s financial health: 

1. Price to Earnings (P/E) Ratio

This is the most popular tool for a reason.

• The P/E ratio tells you how much you’re paying for every Rs.1 of profit the company makes. A low P/E can be a sign of a bargain.
• The formula of P/E Ratio is to divide the current market price of the stock divided by the EPS (Earnings Per Share). For example if the stock price is Rs.500 and its Earnings per share (EPS) is Rs.50, then the P/E ratio will be 10 (500/50). 
• Note investors shall always compare the other companies in the same industry as well because a P/E ratio of 15 might be high for a steel company but it might be very low for a tech company. 

2. Price to Book (P/B) Ratio

This is another way to analyse the opted share. 

• The P/B ratio compares the stock price to the company’s “book value.” Consider the book value as the company’s net worth on paper meaning the worth of the company after selling everything and paying all its debts.
• To calculate the P/B ratio investors need to divide a company’s market capitalization by its book value of equity as per the latest reporting period.   
• A P/B ratio below 1 is considered very good for investors as it means you are buying the company share for less than what its assets are worth. 

3. Net Cash Flow

• Cash flow generally means the amount of cash that is coming in the company after all the expenditures are done. A company may report highly profitable but it still might be running out on real cash.  
• Investors shall look for companies which have more cash coming consistently rather than cash going out of the company, as this shows that the company is having a healthy business that can easily pay its bills, invest in their future growth and also reward its shareholders. 

Read Also: How to find and identify undervalued stocks

Who Should Invest in Undervalued Stocks?

• Investing in Undervalued stock is a long term game, here investors who are patient for the results shall generally invest in such stocks. If you are looking for quick profits you should avoid this. 
• Value investors bid for something that is being sold by everyone in the market, so investors who are calm and confident about the stock shall go for it. 
• Investors that have basic knowledge about how the businesses work, their financial health and future growth possibilities of companies shall opt for undervalued stocks.

Advantages of Undervalued Stocks

• High Return Potential: The investors goal is to buy it low and sell it high, by investing at a discounted price they set themselves for bigger profits when the stock price eventually rises to its true value.
• Less Stress: Undervalued stocks are generally unpopular and they do not generally fall during the market crash, making your investment less susceptible to the market fluctuations. so they often don’t fall as hard during a market crash.
• Wait & Get Paid: Many undervalued companies have stable businesses that even pay dividends to its investors, which means you can also earn a stable income while you wait for the stock price to go up. 

Disadvantages of Undervalued Stocks

• Value Traps: This is the biggest risk attached to the undervalued stocks, as investors may think they have found out the best stock  but this bargain can be of a failing company giving you an overall loss. 
• Long Wait: The waiting time of the stock revival can be anything from 1 week to 1 year due to which the returns are not certain as per your expectations. 
• Stagnant Investment: Investors can miss out on some fast growing stocks due to value invested in some stocks that might give returns in the future, making your investment stagnant. 

Read Also: 10 Best Copper Stocks in India

Conclusion 

Value investing is a smart, proven way to build wealth over time but it is not just about the timing of the market or entering the market trending shares. It is about having knowledge, looking at the company’s fundamentals and understanding the changing market along with all this, investors need to have patience and discipline as using all these strategies the end result can be highly rewarding.  

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