Stocks that are undervalued have a price that is less than their actual, or “fair,” value. Stocks may be undervalued for a variety of reasons, including the company’s familiarity with the public, unfavourable headlines, and market meltdowns.
Most fundamental analysts make the crucial assumption that market prices will eventually adjust to represent an asset’s true value, presenting possibilities for profit. The secret is to seek out high-quality equities at prices below their fair values rather than worthless ones at exorbitant discounts. The distinction is that, over time, high-quality equities will increase in value.
Remember that you should never base your judgments solely on your personal ideas; instead, you should always acquire accurate financial information about the stock you wish to trade.
Why Are Stocks Undervalued?
Various factors might cause stocks to become undervalued, including:
- Changes in the market: Stock prices may decline as a result of market gyrations or corrections.
- Unexpected bad news: Stocks may become undervalued as a result of unfavourable publicity or economic, political, or societal changes.
- Cyclical fluctuations: Share prices are impacted when stocks in some industries perform poorly over a period of time.
- Unpredicted outcomes: When equities don’t perform as expected, the price may drop.
- Undervalued and overvalued stocks.
- Observing cheap stocks: eight methods.
So, how do investors identify stocks that are undervalued? As a part of their fundamental analysis, they primarily use ratios. Here are eight ratios that traders and investors frequently employ to identify inexpensive stocks and ascertain their genuine value:
- P/E ratio (price-to-earnings ratio)
- Debt-to-equity (D/E) ratio
- Revenue from equity (ROE)
- Income yield
- The yield on dividends
- Present ratio
- Price-Earnings Ratio of Growth (PEG)
- Price-to-book (P/B) ratio
We examine each of these in further detail in the section that follows. A “good” ratio will differ depending on the industry or sector because they all face various competitive challenges.
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P/E Ratio (Price-to-earnings ratio)
The ratio for valuing a firm that compares its current share price to its earnings per share is called the price-to-earnings ratio (EPS). The price multiple or earnings multiples are other names for the price-to-earnings ratio.
Investors and analysts use P/E ratios to assess the comparative value of a company’s shares in an apples-to-apples comparison. It can also be used to compare a company to its past performance or to compare broad markets over time or to one another. P/E estimates can either be forecast or trailing (backwards-looking). The following is the calculation and formula utilised for this process.
P/E Ratio = Market Value Per Share/Earnings Per Share (EPS)
The current stock price may be easily determined by entering a firm’s ticker symbol into any finance website; however, EPS cannot be determined as easily.
Occasionally, analysts who are interested in long-term valuation patterns will take into account the P/E 10 or P/E 30 metrics, which, respectively, average the last 10 or prior 30 years of earnings. These longer-term measurements can account for fluctuations in the business cycle, which is why they are frequently used when attempting to determine the overall value of stock indices like the Nifty 50.
Forward P/E Ratio
The two most popular P/E ratios are the forward P/E and the trailing P/E, which take into account these two forms of EPS measures. Instead of using trailing numbers, the forward (or leading) P/E makes use of future earnings predictions.
This forward-looking measure, also known as “expected price to earnings”, is helpful for comparing current earnings to projected earnings and for painting a more accurate image of what earnings will look like—without modifications and other accounting adjustments.
However, the forward P/E metric has built-in issues, such as the possibility that businesses could overestimate earnings in order to beat the predicted P/E when the following quarter’s earnings are revealed.
Other businesses might overestimate the estimate and then lower it before making their subsequent earnings report. Additionally, estimates from outside experts could differ from those made by the corporation, which could be confusing.
Trailing P/E Ratio
By dividing the current share price by the total EPS earnings over the previous 12 months, the trailing P/E is based on past performance. The reason it’s the most widely used P/E metric is that it’s the most objective—provided the company honestly reported earnings.
Since they don’t trust other people’s earnings projections, some investors prefer to look at the trailing P/E ratio. However, the trailing P/E has some drawbacks as well, especially since a company’s past performance does not predict its future behaviour.
Another issue is that the stock prices change while the EPS number stays the same. The trailing P/E won’t accurately reflect changes in the stock price if a significant company event causes it to move sharply higher or lower. Since earnings are only disclosed once a quarter while stocks are traded continuously, the trailing P/E ratio will fluctuate along with the price of a company’s stock.
The future P/E is therefore preferred by some investors. Analysts anticipate higher earnings if the forward P/E ratio is lower than the trailing P/E ratio. Analysts anticipate lower earnings if the forward P/E ratio is higher than the current P/E ratio.
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Debt-to-equity (D/E) ratio
The debt-to-equity (D/E) ratio, which measures a company’s financial leverage, is determined by dividing all of its obligations by the value of its shareholders. An essential statistic in corporate finance is the D/E ratio. It gauges how much debt a business is using to finance operations as opposed to fully owned cash. More specifically, it shows whether shareholder equity would be sufficient to pay off all debts in the event of a downturn in business. A specific kind of gearing ratio is the debt-to-equity ratio.
D/E Ratio = Total Liabilities/Shareholder’s Equity
The balance sheet of a corporation contains the data necessary for the D/E ratio. Total shareholder equity must equal assets less liabilities. Deep research is typically required to determine a company’s true leverage because the ratio might be skewed by retained earnings, losses, intangible assets, and pension plan modifications.
Analysts and investors frequently alter the D/E ratio to make it more relevant and simple to compare between other equities due to the uncertainty of some of the accounts in the key balance sheet categories. The inclusion of short-term leverage ratios, profit performance, and growth projections can also enhance the analysis of the D/E ratio.
The D/E ratio, which compares a firm’s debt to the value of its net assets, is frequently used to determine the extent to which a company is using debt to leverage its assets. A corporation that has been aggressive in using debt to finance its growth would have a high D/E ratio, which is frequently linked to high risk. A corporation may produce more earnings if significant amounts of Debt is used to support growth more than it otherwise would.
Shareholders should anticipate profit if leverage boosts earnings by more than the debt’s cost (interest). Share values, however, could fall if the cost of debt financing outweighs the rise in revenue. Depending on the state of the market, debt costs can change. Therefore, unprofitable borrowing might not be immediately obvious.
Changes in long-term debt and assets typically have a greater influence on the D/E ratio than changes in short-term debt and short-term assets since they are typically larger accounts. Other measures can be used by investors to assess a company’s short-term leverage and its capacity to pay off debt commitments that must be repaid in a year or less.
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Revenue from equity (ROE)
A proportion called return on equity (ROE) compares a company’s profitability to its equity. Divide shareholder equity by net income to get the return on equity (ROE). Due to the company’s high-income generation compared to shareholder investment, a high ROE may indicate that the shares are undervalued.
An example of ROE: ABC has INR 500 Crore stockholder equity and a net income (income minus liabilities) of INR 100 Crore. Due to this, the ROE(100/500) is equivalent to 20%.
The normal ROE for a stock’s peers will determine whether ROE is considered good or terrible. For instance, utilities have a large number of assets and debt on their balance sheet, but only a modest amount of net revenue. In the utility business, a typical ROE can be 10% or less. A retail or technology company with lower balance sheet accounts in comparison to net income may often have ROE levels of 18 percent or higher.
The rule of thumb is to aim for an ROE that is comparable to or slightly higher than the industry average for companies doing the same type of business. Assume, for instance, that XYZ, a company, has consistently produced an ROE of 18% over the past five years, as opposed to the peers’ average of 15%. Investors can draw the conclusion that XYZ’s management does a better job at generating profits from the company’s assets than the management of other companies.
From one industrial group or sector to another, ROE ratios will differ greatly in terms of being relatively high or low. Still, investors sometimes take the shortcut of assuming that anything below 10% represents bad performance and that the return on equity should be closer to the long-term average of the Sensex (14%).
Assuming that the ratio is broadly in line with or slightly above the average for its peer group, ROE can be used to determine sustainable growth rates and dividend growth rates. Although there may be some difficulties, ROE can be a useful starting point for creating future projections of a stock’s growth rate and dividend growth rate. These two formulas are functions of one another and can be used to compare businesses more easily.
By dividing the ROE by the company’s retention ratio, one may calculate the future growth rate of a company. The percentage of net income that a corporation keeps or reinvests in order to support future growth is known as the retention ratio.
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Income Yield
The P/E ratio in reverse can be thought of as the income yield. It is EPS divided by the price rather than the price per share divided by earnings. If the income yield is higher than the typical interest rate the Indian government pays on borrowing money, some traders believe the company is cheap (known as the treasury yield).
An example of an income yield: ABC’s share price is INR 50 and its EPS is INR 10. The income yield (10/50) will be equivalent to 20%.
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Yield On Dividends
A company’s annual dividends, or the portion of profits paid out to stockholders, are compared to its share price to determine its dividend yield. Divide the annual dividend by the current share price to get the percentage. Companies with high dividend yields are preferred by traders and investors because they may be more stable and generate big returns.
An example of dividend yield: Each year, ABC pays out INR 5 in dividends per share. Given that the share price is INR 50 right now, the dividend yield is 10% (5/50).
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Current Ratio
The current ratio is a metric used to assess a company’s debt-paying capacity. Simply dividing assets by liabilities yields the answer. If the current ratio is less than 1, the available assets are typically insufficient to satisfy the liabilities. The risk that the stock price may decline further, possibly to the point of becoming undervalued, increases with the decreasing current ratio.
An example of a current ratio: ABC has assets worth INR 2 billion, liabilities worth INR 1 billion, and debt worth INR 1 billion. Hence the current ratio is equal to 2 (2 billion/1 billion).
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Price-Earnings Ratio of Growth (PEG)
The PEG ratio compares the P/E ratio to the annual EPS growth rate as a percentage. A company’s stock may be inexpensive if it has strong earnings and a low PEG ratio. Divide the P/E ratio by the yearly EPS growth rate into percentage points to arrive at the PEG ratio.
Example of a PEG ratio: ABC has a P/E ratio of 5 (price per share divided by EPS) and a 20 per cent annual earnings growth rate. This would result in a PEG ratio of 0.25 (5/20%).
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Price-to-book (P/B) ratio
The P/B ratio is used to compare the company’s book value to the current market price (assets minus liabilities, divided by the number of shares issued). Divide the market price per share by the book value per share to arrive at the figure. If the P/B ratio is less than 1, a stock may be cheap.
An example of a P/B ratio: ABC’s shares are trading at INR 50 a share, while its book value is INR 100, resulting in a P/B ratio of 0.5 (50/70).
Frequently Asked Questions
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Is it good to buy undervalued stocks?
Undervalued stocks can potentially help an investor in making a profitable investment. However, investments in the stock market are subject to market risks and are not guaranteed.
- Which stocks are undervalued now in India?
There cannot be an exhaustive list of undervalued stocks. Please check out Kuvera app to evaluate companies’ P/E Ratio, D/E Ratio, and other important ratios.
- Is it better for a stock to be undervalued or overvalued?
Undervalued stocks have the potential to give better returns than overvalued stocks, in the long run, however, investments in the stock market are subject to market risks and are not guaranteed.
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