What Makes an Undervalued Stock?
An undervalued stock is a stock that trades for less than what it is worth. That means the share price does not reflect the fair value of the underlying company. Stocks generally tend to be undervalued or overpriced, as the share price often does not reflect their true value. There are a variety of reasons as to why this happens.
The stock might be undervalued because of some negative news that came out recently. Remember when Zion Williamson’s shoe exploded on national TV? Nike shares fell the next day. In the same way, a stock could be overpriced if investors are hyped about an unproven technology being developed by the company.
These events tend to have an effect on stock prices, and investors seize the opportunity and buy quality companies that now trade below their true value. As the decline in price tends to last only for a while, investors make a profit when the stock returns to its fair value.
What is Not an Undervalued Stock?
Undervalued does not mean cheap. It just means that the current stock price does not reflect the true value of the assets, growth potential, or profitability of the company.
For example, if two stocks trade at $13 and $225 per share, people would think the first one might be undervalued, as it is cheaper. The first stock is General Electric, the American multinational conglomerate. The second one is Fiverr, an online marketplace for freelance services. In fact, Fiverr is an undervalued stock.
The stock price alone doesn’t tell you whether the stock is undervalued or overpriced. Because it’s not just about the stock price, it’s more about what you get for the price you pay. Investors refer to this as the intrinsic value of a stock.
What is Intrinsic Value?
Intrinsic value is a measure of what a stock is actually worth. The intrinsic value of a stock is derived from analyzing the fundamentals of the underlying company. Financials (earnings, assets, free cash flow, etc.) and business fundamentals (business model, target market, management, etc.) are studied to determine the intrinsic value of the stock.
Investors generally use intrinsic value to determine whether a stock is undervalued or overpriced.
How to Find Undervalued Stocks?
You can start by using a stock screener. It allows you to filter companies based on unique parameters. You can choose various parameters including financial ratios (P/E ratio, EV/EBITDA, etc.), industry, and market cap among other factors, to narrow down your search. Once you have a very specific list of stocks, start your due diligence on each. Also, undervalued stocks work best with the value investing strategy.
What is Value Investing?
Value investing is an investment strategy that is focused on the intrinsic value of a stock rather than the stock price. Value investing focuses on buying undervalued stocks, at a discount. As the market moves up and down, the stocks might go on ‘sale’ during a particular period, that’s when value investors buy their favorite undervalued stocks. To quote Seth Klarman, billionaire value investor, ‘We define value investing as buying a dollar for 50 cents”.
Margin of safety is an important aspect of value investing. It is buying undervalued stocks on a discount, so the money you pay for a share is significantly below its intrinsic value.
Imagine you found Apple to be undervalued when it was trading at $55 per share when it was actually worth $65. But instead of buying it for $55, you wait for the price to come down. And, you buy the shares when the stock price comes down to $35. You will have a profit of $30 per share, just by waiting for the stock price to reach its intrinsic value, whereas if you had bought the stock at $55, the profit would have been reduced to $10. On top of that, if the company makes more money, your profits will increase. And in the case of Apple, currently, the stock trades at $134 a share.
Value investing can be especially beneficial when you are trying to build long-term wealth. Warren Buffett, one of the richest people in the world, is the best-known value investor today.
So, if you want to know more about value investing, check out The 8-Step Beginner’s Guide to Value Investing. Even if you are new to investing, this book will help you understand how value investing works and how you can build long-term wealth.