Undervalued shares appear in a situation where the stock shares are sold in the market at low prices relative to their intrinsic worth. This intrinsic value is based on specific key financial parameters, including cash flow, profits, return on assets, liabilities as well as others. Nonetheless, for several reasons, the market price of a stock may not represent the company’s current value fully. 

For example, young firms that are not well known to analysts and shareholders may see improved sales and earnings without it being reflected in their market value. This article includes the most effective ways to find undervalued stocks for investments.

What Are Undervalued Stocks?

These are stocks that are traded at the current market price lower than their true worth in the stock market.

The principle on which this fundamental analysis is based is that the market price will inevitably move towards a fundamental value, providing the trader with a chance for profit. But, the search for the undervalued stock is not as simple as searching for cheap stocks. It is the careful identification of undervalued shares; shares that have not been priced efficiently by the market earlier.

Nine Ways to Spot Undervalued Stocks

There are numerous financial ratios, commonly known as the tools of the fundamental analysis, which investors use for the identification of undervalued stocks. They are as follows:

Price-to-Earnings Ratio (P/E)

P/E ratio considers a particular company’s current share price relative to its earnings per share (EPS). Where the P/E ratio is low, this could indicate that the stock is cheap at the moment, which means undervalued.

Example: It can be calculated by using the formula that if the price of a particular stock is $50 and the EPS is $10, the P/E ratio would be equal to 5. This is as good as stating that you spend five dollars to make one dollar of profit.

Debt-to-Equity Ratio (D/E)

The D/E ratio focuses on the firm’s total liability to its shareholders’ equity. A higher ratio means higher liabilities or debt level in the organization. It is relevant to compare this ratio with other companies in the same industries.

Example: Suppose that a company has total debt of $1 billion and total equity of $500 million, the D/E ratio is equal to 2. This translates to $2 of debt for every dollar of equity.

Return on Equity (ROE)

As the name suggests, ROE is designed to determine how much profit a company generates in relation to the shareholders’ equity. A high value of ROE can be an implication that the stock is undervalued at the moment.

Example: For instance, a company has net income of $90 million and equity of $500 million, then the ROE is 18%.

Earnings Yield

Earnings yield is calculated as P/E ratio or EPS/S; S stands for share price. If it is higher than the average treasury yield, it is deemed attractive.

Example: So if a company has an EPS of $10 on its stock price of $50, the earning yield is 20%.

Dividend Yield

Dividend yield is calculated as the ratio of a firm’s annual dividend rate to its stock price. More often than not, a higher dividend yield means a healthy and profitable business environment.

Example: Even if a company gives dividends in the tune of $5 per share, and the price per share is $50, the level of dividend yield is considered at 10%.

Current Ratio

The current ratio reflects the current level of company’s solvency and its ability to meet the existing short-term obligations by using the so-called short-term assets. If the current ratio is less than 1, then it may mean that a business entity is in trouble financially.

Example: So if a certain company has $1.2 in equity and liabilities at $1 billion, the current ratio is equal to 1.2.

Price-to-Earnings Growth Ratio (PEG)

The PEG ratio arising from the P/E ratio multiplies it by the rate of growth in earnings. Another value that is widely used is PEG ratio whereby a low ratio means that the share is possibly underpriced.

Example: If a firm has a P/E ratio of 5 and annual growth rate in earning per share of 20%, then PEG ratio is 0.25.

Price-to-Book Ratio (P/B)

The P/B ratio relates the current stock price to book value of the company’s assets. A reading below that of 1 for P/B ratio can give a signal that a stock is undervalued.

Example: If a stock is selling at $50, and its book value is $70, then the P/B is equal to 0.71.

Free Cash Flow (FCF)

FCF may be defined as the amount of cash that is produced by a given firm in a given period less such expenditures. This indicates the firm’s capacity to generate funds for operations, to declare and pay dividend (s) and to repurchase share (s). Increasing FCF can mean the stock is cheap.

Example: Take a case of Company ABC, it generates a free cash flow of $100M for the year. This means after giving capital expenditures the necessity, ABC was left with $100 million that can be used for operations, dividends to the shareholders or repurchasing of shares.

Reasons Stocks Become Undervalued

Stocks can become undervalued due to a variety of factors, including:

• Economic Downturns or Market Corrections: Market sentiments are subdued in the event of an economic downturn and this affects all the securities in the market including stocks in various industries. At the broad level this leads to an undervaluation for the stock as investors take their money back due to these uncertainties.
• Company-Specific Issues: A firm’s internal dynamics affect investor decisions and stock prices. Conversely, internal factors, including poor performance, managerial changes or unfavourable changes, may also lead to low investors’ confidence and poor stock prices. These factors are likely to produce volatilities and risks that can push down the stocks and make them undervalued.
• Industry-Specific Trends: Market factors such as the changing nature of business within the industry and changes in the investors’ attitude regarding the stocks have a significant impact on stock prices of the companies in the given sector. Investors’ perception of the market and their tendencies of herd mentality or shifting focus to a particular sector can lead to stocks being over or under-priced relative to their intrinsic value.
• Negative Press or Poor Earnings Reports: This can be noticeable when there are negative media published about the company or when the company releases its financial statements with lower results, as investors tend to sell off shares. Consequently, stock markets tend to react to negative information through temporary stock price adjustmentor changes in the relative stock price level, thus providing only short-term signals as to whether or not a company has been adversely affected.
• Political Instability or Policy Changes: A change in government policies and regulations can be the worst nightmare for markets and investors since political influences are sure to come. Political risks, because of unpredictability, can transpire into stock market variations affecting fair share pricing due to changes in risks undertaken.

How to Invest in Undervalued Stocks?

There are two options available for this; you can either trade, or invest in undervalued securities. It is the trading where one bets on the company’s shares by using contracts for difference products without actually holding any of them. Investing entails the act of purchasing securities and directly owning these securities with an aim of attaining large profits in the long-run.

There is simply no way to deny that leverage increases the possibilities of profits while also making it possible to easily lose more money. Remember to always control your risk before you engage in your trading activities.

Conclusion

Searching for the potential and involved stocks and investing in them involves understanding of fundamental analysis. If one selects and utilizes the correct financial ratios and takes into consideration a range of aspects, the subject will reveal possible investment prospects. However, one should not forget the fact that each investment process has inherent risks, so be well-informed and do not put all your money into one investment.

Therefore, by adopting the above guidelines, one is in a position to improve on chances of identifying undervalued stocks hence possibly increasing on the gains in the investment ventures.