We all want to invest in good stocks that can generate multi-bagger returns. But before investing, it’s important to learn how to differentiate these diamonds from the dust. This article will provide you with a basic overview of stock valuation and approaches for determining if a stock is undervalued or overvalued, Let’s have a look at how to find undervalued stocks.

Investing in undervalued stocks can give a significant boost to your portfolio once the prices of such stocks start appreciating. This concept of Value Investing, which was coined by Benjamin Graham and later popularized by Warren Buffet holds true even today. 

What is Value Investing?

It’s nearly impossible for an individual investor to outperform the market over the long term, but there exists one such successful strategy that has been able to achieve this!

And that proven technique is value investing. Value investing is a type of investing that focuses on finding undervalued stocks and making profits out of them. It is based on the concept that every stock has an intrinsic value. Intrinsic value represents what the stock is actually worth. 

Rather than relying on technical indicators like moving averages, volume, or momentum indicators, value investing focuses on the intrinsic value of a stock.

Understanding the company’s financials, such as Profit and Loss Statement, Balance Sheet, Cash Flow Statement, fundamental analysis, analyzing important ratios, looking into qualitative aspects, etc., is necessary for determining the company’s intrinsic value.

The Difference Between Price and Value

“Price is what you pay, Value is what you get” –Warren Buffet

There is a difference between stock price and its intrinsic value, and not every stock price would always reflects the stock’s true value.

The objective of value investing is to purchase shares that are trading at a significant discount to their intrinsic values (which means they are trading cheaper than their true or actual value). 

If the intrinsic value of a stock is more than its current share price, then the stock represents a good investment opportunity. The larger the discount to its intrinsic worth, the more appealing the investment opportunity is. 

Whereas if the intrinsic value is less than the current stock price, the stock is said to be overvalued and should be avoided. 

The idea is that, once you buy a stock that is undervalued, the share price eventually (sooner or later) increases toward its intrinsic value, and that’s how a value investor makes massive profits. So, if you can figure out a company’s intrinsic value, you’ll be able to reap the benefits of these great deals.

Now that you know What Value Investing is, here’s the million-dollar question: 

How to Find Undervalued Stocks?

One of the ways to assess if a stock is undervalued or not is to apply a few valuation metrics along with a few ratios and compare them to companies similar to it; or with the industry averages etc.

Let us discuss some of the key indicators and valuation metrics to determine the stocks are undervalued at any given moment:

How to Find Undervalued Stocks #1 – Price to Earnings Ratio

If you see the current stock prices, a single MRF Share is trading at around ₹ 68,000. At the same time, CEAT Ltd is available for about ₹ 1,000 a share.

Now, if I ask you which stock is more costly, some of you might think MRF is more expensive than CEAT since MRF’s share price is so high, right? 

But that is the absolutely wrong approach to decide. Many beginner investors who are new to the world of the stock market might end up making the mistake of valuing a company only on the basis of its stock price, which is not right.

So then what is the right approach to check a company’s valuation?

The Price-to-Earnings Ratio, or PE Ratio, is one of the most significant and extensively used metrics for determining how costly a company might be in relation to its earnings that are generated every year.

PE Ratio is calculated by dividing the Share Price by Earning per Share (EPS) of the company.

PE Ratio = Price Per Share / Earning Per Share

Now let us try to understand what exactly PE Ratio is and why it is so significant. 

As an investor, what should be the most essential criteria to gauge the performance of the company? The answer would be Earnings. So at the end of the day, we are interested in knowing how much earnings the company has generated.

If the profits increase, more and more people would be willing to invest in that company. This would increase the demand, and eventually, the share price too will increase. 

And if profits are low and falling over time, then people would want to sell their shares. So the supply will increase, the demand for the company will decrease, and hence the share price will fall. In short, the stock price should ideally move in relation to its earnings. 

In an ideal world, the stock price should move with the earnings. But that doesn’t happen in the real world. Sometimes the share price goes up even if there’s no substantial increase in earnings.

This could happen because of a lot of factors such as a change in the macro-environment like government policies or schemes, or micro factors, such as the anticipation of higher earnings in the future, or it could simply be for no reason at all. 

And sometimes, even when the earnings are strong, the price goes down. For e.g during Covid Outbreak, the market crashed and the share prices of all the companies fell irrespective of their earnings.

While checking the company’s valuations, it’s critical to look at the company’s PE ratio and then compare it to the industry’s PE ratio to determine if it’s lower or higher than the industry average.  If it’s lower, then it’s possible that the stock is undervalued. And if it is higher than the industry average, then it might be overvalued.

Now, let’s compare the PE Ratio of MRF and CEAT. You can easily find these ratios on Trade Brains Portal.

PE Ratio of Ceat Ltd

CEAT Ltd.’s PE ratio is 20.45

PE Ratio of MRF Ltd

MRF Ltd.’s PE Ratio is 34.48

The PE of the Tyre Sector is around 22, but the PE of MRF Ltd. is 34.48, which means it is trading at a higher level than its sector PE. At the same time, the PE of CEAT Ltd. is around Sector PE.

ALSO READ: Five Beginner Mistakes in the Stock Market!

How to Find Undervalued Stocks #2 – PEG (Price/Earnings-to-Growth Ratio)

The price-to-earnings-growth ratio, also known as the PEG ratio is also one of the important ratios from the valuation perspective. Unlike PE Ratio, the PEG ratio takes into consideration the company’s earnings growth rate. To calculate the PEG ratio, we take the PE ratio and divide it by the growth rate of those earnings.

                              PEG Ratio =         P/E Ratio

                                                             Earnings Growth Rate

The lower the PEG ratio, the more likely the company may be undervalued given its future earnings projections.

How to Find Undervalued Stocks #3 – PBV (Price/Book Value) Ratio

PBV or P/BV Ratio signifies the relationship between the total value of a company’s outstanding shares and its book value of equity.

It can be computed as follows: 

                               PBV Ratio =  Price per Share 

                                                     Book Value per share

While checking on Trade Brains Portal, we found Price to the Book Value ratio of MRF Ltd. is 2, whereas the Price Book Value ratio of CEAT Ltd is 1

As a thumb rule, a stock with a lower P/BV ratio is considered to be undervalued compared to that with a Higher P/BV ratio.

How to Find Undervalued Stocks #4 – Price-to-Cash Flow (P/CF) Ratio

P/CF or Price-to-Cash Flow Ratio is also a critical metric that compares the price of a stock to its operating cash flow per share. 

                         P/CF Ratio =      Price per Share

                                                    Operating Cash Flow per share

The P/CF Ratio of MRF Ltd is 12.86

The P/CF Ratio of CEAT Ltd is 5.36

(Source: Trade Brains Portal)

A stock with a low P/CF multiple is considered to be undervalued. One of the advantages of the Price-to-Cash Flow Ratio over the Price-to-Earnings Ratio is that it cannot be manipulated as easily as the company’s earnings, which are impacted by accounting treatment like providing for depreciation and other non-cash expenses. 

Even though some companies have healthy cash flows, they may appear unprofitable owing to large non-cash expenditures.

Other Important Factors to Find Undervalued Stocks

By using the Stock Screener available at the Trade Brains Portal, you can perform the initial screening for a company that could have the potential to be undervalued at the moment.

But it is crucial to continue digging deeper into that company’s fundamentals and really understand what they’re about.

It is critical to look into the quality of the company’s management, emerging industry trends, disruptiveness of the business model, growth outlook for the future, and other valuable details that can’t really be quantified.

In Closing

Investing in Undervalued Stocks can create huge wealth for your future. To assess whether a company is undervalued; overvalued or fairly valued it is essential to check the valuation ratios such as PE Ratio, PE/G Ratio, P/BV Ratio, P/CF Ratio, etc., and compare them with the Industry average.

Along with these valuation metrics, it is also necessary to have an analytical judgment about the company’s future outlook and growth prospects, and emerging trends in the industry or market in order to identify undervalued stocks successfully.

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