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An undervalued stock is more or less what it sounds like: A stock that is trading at a price that may be less than its intrinsic value, or that an investor may think is underpriced by the current market.
In effect, an undervalued stock may be a bargain — and an investor may believe that by purchasing shares of the stock, it’ll appreciate and they’ll generate a positive return.
Undervalued stocks are sometimes called value stocks, for the same reason. They’re priced somewhat lower than their potential value, in light of the company’s earning power or profitability. As such, they may appreciate in value.
Read on to learn more about undervalued stocks, how to try and find them, and what to watch out for.
Key Points
• An undervalued stock is one trading below its perceived intrinsic value, representing a potential bargain that investors believe may appreciate and generate positive returns over time.
• Stocks can become undervalued due to negative news cycles, broad market sell-offs, cyclical downturns, or simply because a company flies under investors’ and analysts’ radars.
• Key financial metrics for identifying undervalued stocks include the price-to-earnings (P/E) ratio, debt-to-equity (D/E) ratio, return on equity (ROE), and price-to-book (P/B) ratio.
• Value traps are a risk to watch for. A stock may appear undervalued but could simply be declining in value, meaning a higher risk of loss.
• Finding undervalued stocks is not an exact science; investors must conduct thorough due diligence before placing trades.
What Are Undervalued Stocks?
Undervalued stocks, also known as value stocks, are stocks that may be trading less than their intrinsic value, given certain company fundamentals such as earnings or profitability. It’s similar to finding a bargain at the store — an investor may feel like they’ve stumbled upon an overlooked investment opportunity that could potentially help boost their returns, assuming the stock appreciates.
Unfortunately, there’s no way to be absolutely certain that a stock is undervalued. That said, investors can engage in various forms of research and fundamental analysis to try to determine a stock’s intrinsic value.
What Is Fundamental Analysis?
Fundamental analysis enables investors to assess the value of a stock through a detailed investigation into the company’s business operations, its financial health, and the broader economic context and competitive landscape. Typically, investors will examine the company’s balance sheet, income and cash flow statement. For example, investors may look for:
• Lower price-to-earnings ratios (P/E ratios)
• A solid balance sheet
• A history of steady cash flow and profits
Investors may want to also examine the management team.
By conducting this due diligence, investors may be able to decide whether the share price of the stock is fair or undervalued. This is an important step, whether you’re investing online or through a traditional brokerage.
Investors who are interested in buying stock can then compare the stock’s current market value to what these fundamentals may indicate about the company’s underlying value.
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Why Do Stocks Become Undervalued?
A stock may become undervalued for several reasons. For instance:
• Share prices may decline for a particular stock if there is some sort of negative news story concerning the stock or company or simply the sector it’s in.
• A stock could simply see its value decline as a part of a market-wide sell-off, or a cyclical downturn.
• A stock could also fly under the radar for investors and analysts, meaning that many people don’t know much about it or its intrinsic value.
• A company may be complex or bring something new to the market that people don’t quite understand, and investors have yet to accurately price its shares, accordingly.
Again, there may be one or several reasons — sometimes none at all.
How to Spot Undervalued Stocks
Investors hoping to find undervalued stocks can look at some of the stock’s fundamentals, including financial ratios. That may involve learning how to analyze a stock more deeply.
Price-to-Earnings (P/E) Ratio
Investors can look at a stock’s price-to-earnings ratio, or P/E ratio, which can give them an idea of a stock’s intrinsic value. This ratio is calculated by dividing its current price per share by its earnings per share, which will show how expensive a stock is relative to how much money the company is making. That can help investors decide whether they think a stock is over or undervalued.
Debt-to-Equity (D/E) Ratio
Investors can also calculate a stock’s debt-to-equity, or D/E ratio. That measures a company’s debt, and its ability to pay that debt off. A lower D/E ratio is generally better – and can also help better inform investors looking for undervalued stocks.
Return on Equity (ROE)
The return on equity, or ROE percentage, helps determine a company’s overall profitability relative to its equity. Investors can calculate it by dividing net income or profits by shareholder equity. This can also help give investors an idea of a company’s current value relative to its share price — yet another hint that a company may or may not be undervalued.
Price-to-Book (P/B) Ratio
The price-to-book ratio, or P/B ratio, also helps gauge a stock’s price against its “book” value — which is determined by subtracting its liabilities from its assets, and then dividing that number by the total number of shares in the market.
Avoiding Value Traps
As noted, just because investors believe that they’ve discovered an undervalued stock doesn’t mean that’s the case. There’s no guarantee that because a stock appears undervalued due to its underlying financials or other factors that it will appreciate. The share price could decline and the stock might lose value — a.k.a., a value trap.
An investor’s estimate of a stock’s intrinsic value is just that: an estimate. There’s no guarantee that the investor’s estimate is correct. And when it comes to conducting fundamental analysis, sometimes ratios can be misleading due to underlying structural factors with a company.
It’s best for investors to proceed with caution, and be aware that their estimates may be inaccurate. Ideally, investors don’t want to find themselves involved more in speculation versus investing.
What Is Growth vs. Value Investing?
As noted, value stocks tend to be undervalued, i.e., their share price doesn’t seem to match a fair market valuation. Value investors try to identify undervalued stocks by examining company financial statements and other fundamentals, and comparing what they learn about the company’s intrinsic value to market price, with the hope of finding a bargain.
The risk is that an undervalued company could be just that: undervalued and with little growth potential. In a worst case, the share price could decline further and an investor could see substantial losses.
By contrast, growth stocks may come with the potential for faster growth and higher earnings and price appreciation. These companies may be newer, and they often reinvest profits in the business to fuel more growth rather than paying dividends. As a result, growth investors typically bet that a fast-moving company will keep up that pace of rapid growth.
The risk, of course, is that even a company that exhibits strong growth potential could stumble, or lose ground to a competitor. Buying stock at a high price could also mean that there’s little room for future growth, and hoped-for returns never materialize.
Growth investors are betting that a company which is growing fast now, may continue to grow quickly in the future. But the risk is that investors jumping into growth stocks may buy a stock that is already valued relatively high. In doing so, they could lose a potentially significant amount of money if prices tumble in the future.
Investing in Undervalued Shares
For inventors ready to start investing in undervalued stocks, most of the legwork comes up front. That is, they’ll need to do their due diligence to find undervalued stocks, and then research them further to make sure they want to buy shares. This could be a part of a broader value investing strategy.
With a list of stocks identified, investing in them is simple: Use a brokerage account to find the stock, determine how many shares you want to buy, and then execute the trade.
The Takeaway
Finding and investing in undervalued stocks is not an exact science. Investors can use various analytical tools to look at underlying fundamentals and try and get a sense of whether a stock is undervalued relative to its market price. But there’s no guarantee that they’d be correct. For that reason, it’s best to proceed with caution.
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FAQ
Are undervalued stocks a good investment?
Undervalued stocks may be a good investment, assuming that investors can correctly identify which stocks are undervalued relative to their market price. It’s not an exact science, and returns are not guaranteed.
What is a value trap in investing?
A value trap is when a stock appears to be undervalued but may simply have an intrinsic value that’s less than an investor may realize. The “trap” is purchasing the stock expecting that it should appreciate, only to see it decline.
How long does it take for undervalued shares to rebound?
There is no time frame in which share prices increase, and no guarantee that any stock’s price will rise at any point.
Do undervalued stocks pay dividends?
Some stocks pay dividends, and that can include some stocks that are determined to be undervalued. Investors should look at individual stocks, and read up on them to determine whether they pay a dividend.
What is the difference between value investing and growth investing?
Value and growth investing are two different investment strategies. Value investing involves buying stocks that an investor believes are undervalued, whereas growth investing involves buying stocks that an investor thinks will see significant growth in the future.
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