Last Updated on Jan 25, 2022 by Manonmayi
Buying low and selling high is considered the ultimate mantra for success in stock market investments. Everyone wishes to catch a stock when it’s bottoming out and sell it after it has scaled lofty heights. But how does one identify stocks that are undervalued? Or how do you judge if a stock is cheap or expensive?
Stock market values companies based on their fundamentals, past financial performance, future earnings growth potential, and other metrics. The intrinsic value of a stock is calculated by looking at all these factors. A combination of quantitative and qualitative analysis is used to determine the intrinsic value of a stock.
Here are some ways you can go about determining whether any particular stock is undervalued or not.
This article covers:
- Balance sheet, profit and loss, and cash flow analysis
- DCF valuation
- Relative valuation
- Evaluation via financial ratios
- Things to keep in mind
Balance sheet, profit and loss, and cash flow analysis
Balance sheet analysis
The balance sheet of a company lists its assets and liabilities. This approach helps an investor determine whether a stock is undervalued by taking into account the size and activity of the asset and liability side of the balance sheet.
A glance at a company’s cash flow will tell you exactly how much revenue a business generates from operations compared to the expenditure. By taking into account the cash flow from operations and investing activities, an investor can determine whether a stock is undervalued or not.
Profit & loss statement analysis
A company’s profit and loss statement provide an insight into its financial performance over a given period. By taking into account revenue, operating expenses, and net profit margin, an investor can determine whether a stock is undervalued or not. If the operating margin and the net profit margin are healthy and yet the stock valuation is not in accordance, then it can be considered undervalued.
DCF stands for Discounted Cash Flow.
Here, a stock’s valuation is done by estimating the future free cash flows of a company and discounting them back to present value. If the price at which a share trades (in the market) today is lower than the valuation arrived, such a stock could be considered undervalued.
This method may vary amongst analysts because of their varying assumptions about future growth rates, capital structure, and discount rates.
This is a qualitative valuation technique where companies are compared against their peers. It basically follows identifying a peer set and then using appropriate ratios and numerical to gauge the relative stand of the company in the market. For example, if we wish to identify undervalued stock in the multiplex industry, we can use the price-to-sales ratio to see which company is a better performer.
Evaluation via financial ratios
Financial ratios are an excellent and time-saving method of evaluating the value of a stock. It helps in company analysis, performance valuation, and predicting the stock’s future. Most of these numbers are readily available and can be used to find the true value of a stock.
Price-earnings ratio (P/E)
The P/E ratio arguably is the most important financial ratio to help determine if a stock is undervalued or even overvalued. It gives the price that investors are ready to pay for each unit of profit. It is given by the formula:
P/E ratio = Current Market Price/Earnings Per Share
If the P/E ratio is less than 15, then analysts usually consider the stock undervalued. A lower P/E ratio indicates that investors are willing to accept a lower return from the stock in exchange for holding on to it. A low P/E ratio could also indicate the stock is unpopular and yet to be discovered by markets.
Price to book ratio
Investors glance at this ratio to assess a firm’s market capitalization compared to its book value. It is given by the formula:
P/B Ratio = Market price per share/Book value per share
A lower P/B ratio means that the market is valuing a company’s book value lower than its actual worth, indicating that it could be undervalued. For running companies, the P/B ratio should never be below book value.
Return on equity (ROE)
The return on equity ( ROE ) ratio is used to measure a company’s profitability by revealing how much profit it generates with the money shareholders have invested in its stock.
Return on equity = Net income/Average shareholder’s equity
If a company has a low P/B ratio clubbed with a high ROE, it usually is indicative of an undervalued stock.
Return on capital employed (ROCE)
The return on capital employed (ROCE) ratio is used to measure a company’s performance by revealing how much profit it generates from its total assets.
ROCE = EBIT/Capital employed
If ROCE is more than the cost of capital, then it usually is considered undervalued.
Price to free cash flow ratio
Free Cash flow is the actual cash that a company has generated through its operations, kept as a reserve for future investment purposes.
P/FCF = Share Price/Free Cash flow
Ideally, a company with a robust cash flow generates more income receivable month on month than what it pays out. An upward trend in this ratio indicates that an investor is paying a lower cost for an increased earning potential. The price to free cash flow ratio can be used to measure undervaluation. If the ratio is less than 10, then it can be considered undervalued.
Things to keep in mind
While all the above-mentioned ratios and techniques can help you pick undervalued stocks, it is important to remember that they are not the only criterion to consider when investing.
Stock markets often keep changing their mood and sentiments. If tomorrow the markets crash, you could find most stocks bottoming out. Now, this does not mean that they are undervalued or make for a good investment option. Similarly, many stocks may see their fortunes rising in an upward trend. This does not mean that they are overvalued.
The thing to remember is that picking a quality stock amidst market turmoils, which is common, can be challenging. A habit of deep reading annual reports and ratios can help you pick brilliant stocks which are still not identified. Do not depend on expert views or TV news breaks to guide your investment decisions.
Stock markets are all about timing. Multibagger stocks can be an excellent example here. Right timing and your investment could grow 10x, 100x, or even more.
By utilising the above-mentioned ratios and techniques, we can identify undervalued stocks and profit by making strategic investments. Do keep in mind that it is crucial to invest at the right time. Following herd mentality may not prove beneficial and can often be counterproductive. So do your own research and consult your financial advisor before investing in any stock or scheme.