The Advantages of Buying Undervalued Stock

Finding an undervalued stock is not easy; an undervalued stock often isn't in the public eye, and if it is, the news might be overly negative. Both these factors can keep a stock subdued while the fundamentals of the company dictate it should be trading at a higher price. While the methods aren't perfect, by utilizing certain approaches to isolate potentially undervalued stocks, your portfolio can see a big boost if the stock comes into favor with investors and fund managers again.

Undervalued Stocks

Undervalued often is confused with cheap, but the two concepts are very different. A stock is undervalued when the price does not accurately reflect the prospects, assets or revenue stream of the company. Just because a stock has a low share price — such as a stock priced below $5 — does not make it a bargain. Price alone cannot be used to determine if a stock is undervalued.

Book Value

One way to determine if a stock is undervalued is to use book value. Book value is the sum of all assets, minus liabilities, minus the liquidation price of any preferred stock. This figure then is divided by the number of shares outstanding. If the result is greater than the current share price, the stock is undervalued relative to the sale value of the assets. This provides a safety net to investors, as even if the company goes bankrupt, the sale of assets is likely to cover a large portion of their investment. The downside is that the stated value of assets in financial statements does not necessarily reflect what the company would receive if an actual liquidation took place. Thus, it is possible the book value might not accurately reflect how protected you are as an investor.

Price-to-Earnings Ratio

Comparing the price of a stock to its earnings provides you with a reference point for whether a stock is undervalued. The price-to-earnings ratio, or P/E, is calculated by dividing the share price by earnings per share, or EPS, for the past 12 months. For example, if a stock is trading at $20 and its EPS for the year were $2, the P/E is 10. This shows how much investors are willing to pay per dollar in earnings. This number alone is usually not sufficient to determine if a stock is undervalued, though. Compare the P/E to other stocks within the same industry to determine which is undervalued. However, a problem with comparing P/E ratios is that one company might be undervalued relative to its peers for a reason — such as poor growth.

Price/Earnings-to-Growth Ratio

Dividing the P/E by expected annual EPS growth provides another ratio that can determine how a stock is valued by investors. Price/earnings-to-growth, or PEG, often is favored by investors over the simpler P/E ratio because it accounts for future growth. Broadly, a PEG of 1 is considered fairly valued, below 1 undervalued and above 1 overvalued. The lower the PEG value of a stock relative to other stocks in the industry, the more undervalued it is. The advantage of buying a low-PEG stock is that the stock is relatively cheap compared to its peers and also has some prospects for growth.

Growth Potential

A company in an emerging field, or developing a new technology, might be undervalued until it can prove its product's or service's usefulness. Determining whether the current stock price is undervalued relative to the future prospects of a company can be a gamble, however. If you are right, and the company produces something that becomes consumed on a large scale, the stock price could skyrocket, providing you an above-average return on your investment. On the other hand, if the company does not produce, then the stock isn't undervalued — it's unlikely to appreciate.

Stock Market Cycles

The stock markets move in cycles, moving lower then higher over time. The cyclical nature of the market often drags good stocks with it, meaning good stocks go "on sale" every once in a while. As the market declines, stocks as a whole become undervalued as pessimism pushes stocks down to extreme levels. This presents an opportunity for investors to buy stocks at a relatively low price. Because stocks often will rise back up as the market cycles, buying these stocks on dips can produce long-term profits. However, there is no precise way to know when a decline will end, so you do face further downside risk.

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