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11 Jun, 2024
5 mins read
What is the best way to profit from stocks? The most frequently received answer would be buying them at their lowest rate and profiting when they are at their peak. But how do you buy such stocks that have future potential or are currently undervalued? Read on to learn the answers to these questions and how to create a successful trading portfolio.
Undervalued stocks are like hidden gems of the stock market. They are worth more than their market price, allowing investors to earn good profits when the market corrects its price range. Undervalued stocks belong to companies with strong fundamentals like good financial health, management, and strong growth potential. The reasons these stocks are undervalued can be multiple, ranging from the market not noticing their potential to short-term market volatility impacting their market price.
Stocks can be undervalued for various reasons that can be intrinsic to the company or part of the macroeconomic effect on the market as a whole. A few reasons that can be attributed to undervalued stocks include,
Economic downturns or market corrections
Company-specific issues such as temporary setbacks, management changes, or regulatory challenges
Industry-specific trends or shifts in investor sentiment
Market inefficiencies or mispricing due to lack of information or investor oversight
Bad press or scandals, poor earnings reports that fall short of analyst expectations can temporarily drive stock prices down
Political instability or changes in policy
Buying undervalued stocks is like looking for a needle in the haystack. It requires investors to find stocks that are trading at values lower than their intrinsic value as well as understand their growth prospects and risk to align with their personal investment parameters. A few considerations for buying undervalued stocks are mentioned below.
Understand the calculation of the intrinsic value of shares through methods like Discounted Cash Flow (DCF) analysis, Price-to-earnings (P/E) ratio, and other valuation metrics.
Examine the company's financial statements and other metrics, including Earnings Per Share (EPS), Return on Equity (ROE), and Debt-to-Equity ratio.
Focus on companies with sound economic viability, long-term growth, and profitability rather than stocks that experience rapid price fluctuations without being backed by strong fundamentals.
Consider the market and industry analysis, along with management quality analysis, to support the company's growth and sustainability features.
Utilise tools like financial screeners, analyst reports, etc., to seek insights and data on stock valuations.
Focus on a diversified long-term portfolio rather than being influenced by short-term market noise leading to frequent trading.
Trading in undervalued stocks is similar to executing any trade. The steps for the same are,
Create a demat and trading account with a reputed broker
Research the target stocks by focusing on their fundamentals, key value investing principles, and the data and analytical tools available on the broker’s platform.
Use surplus funds as capital to be invested to buy or trade in undervalued stocks.
Execute the trade by opening the position.
Regularly monitor the trade to track performance and market conditions.
Adjust your stop-loss and take-profit levels as needed.
Close the position when your target is reached or if market conditions change.
Investors can use the following key indicators to identify undervalued stocks in India
The Price-to-Earnings (P/E) ratio is a fundamental indicator used to assess if a stock is undervalued. It is calculated by dividing the stock’s current market price by its earnings per share (EPS). A lower P/E ratio compared to the industry average or historical levels may suggest that the stock is undervalued. This indicates that the market may be underestimating the company’s earnings potential, providing a potential buying opportunity for investors.
Dividend yield represents the annual dividend payment as a percentage of the stock's current price. It is calculated by dividing the annual dividends per share by the stock’s price per share. A high dividend yield can indicate that a stock is undervalued, especially if the company has a strong track record of maintaining or increasing dividends. This metric is particularly appealing to income-focused investors seeking steady returns.
The Price-to-Book (P/B) ratio measures a stock’s market value relative to its book value. It is calculated by dividing the current price per share by the book value per share. A P/B ratio below 1 suggests that the stock might be undervalued, indicating it is trading for less than the company’s net assets. This ratio is particularly useful for evaluating companies with substantial tangible assets, such as manufacturing or real estate companies.
The Debt-to-Equity (D/E) ratio compares a company’s total liabilities to its shareholder equity. It is calculated by dividing total debt by total equity. A lower D/E ratio indicates that a company less relies on borrowing to finance its operations, reducing financial risk. Stocks of companies with low D/E ratios might be undervalued if their market prices do not fully reflect their lower financial risk and stable capital structure.
Free Cash Flow (FCF) is the cash generated by a company after accounting for capital expenditures necessary to maintain or expand its asset base. A positive and growing FCF indicates that the company has the financial flexibility to fund operations, pay dividends, and reduce debt. Stocks of companies with strong FCF that are trading at relatively low prices might be undervalued, reflecting a potential disconnect between cash generation capability and market valuation.
Return on Equity (ROE) measures a company's profitability relative to shareholder equity. It is calculated by dividing net income by shareholder equity. A high ROE indicates efficient use of equity capital to generate profits. If a company has a high ROE but its stock price is low compared to its peers, it could indicate that the stock is undervalued, as the market may not fully recognise the company's ability to generate strong returns on equity.
The Current Ratio assesses a company’s ability to pay its short-term obligations with its short-term assets. It is calculated by dividing current assets by current liabilities. A current ratio above 1 suggests that the company can cover its short-term liabilities with its short-term assets, indicating good liquidity. A company with a strong current ratio and trading at a low stock price might be undervalued, as the market may be overlooking its short-term financial health and liquidity position.
Investing in undervalued stocks remains a timeless strategy for building a robust long-term portfolio. While it is tempting to rely solely on technical analysis or short-term fluctuations, the true value lies in fundamental analysis. Seasoned investors understand that no single indicator can definitively gauge the undervaluation of the stock. Instead, a comprehensive approach that combines ratio analysis with a deep understanding of the underlying business is the answer to finding these gems. Investing in undervalued stocks is also a key investment strategy for aggressive investors, and also aligns with principles of value investing emphasising a patient and long-term perspective for sustainable growth and returns.
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