Investing in the stock market is seen as a gamble by many but adopting a sound strategy could bring attractive returns over time. A smart move that many investors believe is to buy stocks that are undervalued in the market today. This strategy is called value investing.
What are undervalued stocks?
The market value is the value at which a stock can be purchased and sold on the stock market. The intrinsic value is the value calculated based on the company’s financial statements. When the market value of a stock is less than its intrinsic value, the stock is undervalued.
Why choose undervalued stocks?
If you buy an undervalued stock today, the stock market is yet to capture its potential in the share price. The market price will invariably tend to merge with the intrinsic value. Owing to the volatility of the market, the market value of a stock surpasses its intrinsic value by many times. When this happens, you will gain a significant amount over your purchase price. It is essential to be patient and wait for the market to sufficiently surpass the intrinsic value of your stock so that you can maximise your profit.
Identifying undervalued stocks
You can identify undervalued stocks with the help of a category of financial ratios known as market value ratios. These ratios compare the market value of a stock with an element from the company’s financial statements. Some of these ratios are –
- Price-to-earnings ratio
The price-to-earnings or PE ratio is calculated as the market value of a share at a particular date and time divided by the earnings per share. Earnings per share (EPS) is profit after all adjustments and tax, as shown in the company’s Income Statement, divided by the number of shares.
- Price-to-book ratio
The price-to-book or PB ratio is another simple yet powerful market value ratio to ascertain whether a stock is undervalued. The numerator or ‘price’ refers to the market capitalisation of a company in this context. This can also be understood by the number of shares multiplied by the market price per share. The denominator refers to the book value of the shares. Book value is calculated as the total assets minus intangible assets of a company.
For PE and PB, a ratio of less than 1 indicates undervaluation, greater than 1 indicates overvaluation.
- Net cash flow
Net cash flow is the net inflow or outflow of cash for a particular period. You can find this number towards the end of the Cash Flow Statement in a company’s financial statements. A higher amount is preferable since more cash flow is seen as a sign of adequate resources to succeed successfully. Cash from Operations can also be taken into account while assessing the viability of a company as a reliable investment avenue.
- Dividend yield
Dividend Yield = (Dividend per Annum / Current Market Price of a Share) X 100
Dividend is that portion of a company’s annual profits which is distributed to the shareholders. A high dividend yield indicates that a company distributes more profit, favouring those looking for a regular income from their investment. You should not see a low dividend yield as negative since a company could use these retained earnings to grow further and bring capital appreciation to its shareholders.
Choosing undervalued stocks to buy could be a good strategy to ensure that your investments are beneficial in the long run. Knowing the what, why, and how and choosing the right avenue is essential. Hence, it is prudent to reach out to an expert who can suggest investment plans that are in line with your financial goals and risk tolerance.
Reach out to one today!