How to Spot Undervalued Stocks: A Value Investor’s Guide

Introduction to Value Investing

Let’s talk simple business. Is it not logical to buy cheap and sell dear? The same is true with stock investments. What makes a share valuable? It is available at a lesser price than its fair value. There it is — the concept of Value investing. To use this strategy, you are essentially looking for undervalued stocks. Do you know who made the most of value investing? Warren Buffet! That’s right.

So, what is the strategy that made Warren Buffet the richest man? Buying undervalued stocks with good fundamentals and selling them only when their fair value is available in the market. 

In this blog, we cover all you need to know about undervalued stocks in India and how you can spot them.

Understanding Stock Valuation

If you want to learn, how to find undervalued stocks, you should start by understanding stock valuation. It simply means you calculate the intrinsic or fair value of a stock. Once you calculate the stock valuation, you can compare it with the market price and determine whether the stock is undervalued or overvalued.

Also Read: The Role of ETFs in Building a Balanced Stock Portfolio

Key Metrics for Identifying Undervalued Stocks

To calculate the fair value of a stock, you should first know how stock value is determined.  Here are some methods of stock valuation you can apply:

Price to Earnings (P/E) Ratio

There are 2 variables in this method:

• Earnings: Earnings refers to the EPS (Earnings per share). This means the net profit available to the shareholders against 1 share.
• Price: It refers to the current market price of the share.

Price to Book Value (P/B) Ratio

Similar to the P/E ratio, the P/B ratio compares the current market price to the book value per share. BVPS is a company’s Net Assets (Assets – Liabilities) per share.

Price to Cash Flows (P/CF) Ratio

Unlike the EPS, which shows income, Cash flows show the actual cash available to the business per share. Investors find it more accurate and use it as an alternative to the P/E.

Discounted / Free Cash Flows (DCF/FCF)

This method uses the premise that the current share price reflects the present value of all the future cash flows. So, to find an undervalued stock, you must predict the future cash flows and the growth rate. Once you get the cash flows, you can calculate the present value and compare it to the current market price.

Dividend Yield

You can compare a company’s dividend yield with its peers and industry average. If the company’s dividend yield is higher than the average, it is an undervalued stock.

Analyzing Financial Statements

Once you identify undervalued stocks, the next step is to analyze whether the company has strong fundamentals. To do this, you have to study the financial statements. Here’s how you can analyze them:

Income Statement

Check the profit and loss statements for multiple years side-by-side. You should compare the following metrics over the years:

• Revenue Growth (Should be steadily increasing)
• Operating Income (Should be steadily increasing)
• Profit Margins (Should be maintained)
• Profitability Ratios (Should be healthy)
• Expenses (Should be controlled)

Balance Sheet

Compare the assets and liabilities of the company. Check whether all these ratios are within the acceptable range:

• Liquidity Ratios
• Solvency Ratios

Cash Flow Statement

The company should have positive cash flows from operations to be a good investment option. The cash flows should be sufficient to cover the short-term liabilities.

The Importance of Market Sentiment

Remember, value investing is for the long term. If you want to capitalize on short-term price movements, you have to factor in market sentiments. Here’s how market sentiments can affect the stock price:

Overreaction to Negative News

Do you remember the recent case of the Hindenberg Report on the Adani Group? The company had strong fundamentals. Yet, one negative news was enough to correct the prices by almost 50%. However, the panic button didn’t last long. Those who saw the opportunity and bought the undervalued stocks at that time were able to ride the price recovery.

Ignoring Fundamentals

Even if a company is making negative news, but the fundamentals are strong, it is only a matter of time. The undervalued stock will recover as the company continues its good performance.

Industry Comparisons: Finding Value

We have discussed the importance of comparing companies with their peers and industry averages. Let’s consider an example to better understand this.

Example: 2 peers, Company A and B, are from the same industry. The industry P/E is 25. The data for both companies is as follows:

Now, compare both companies. Company A has a lower P/E ratio and P/B ratio compared to Company B. The P/E ratio of Company A is also less than the industry average. So, it is clearly an undervalued stock.

However, you should not jump right in! To be sure that Company A is the right choice, you should check its financial statements. If Company A is an undervalued stock with good fundamentals, only then you should invest in it.

Common Mistakes to Avoid

Are there some things to be wary about? What mistakes can you make when identifying undervalued stocks? Here are the mistakes you should avoid:

Excessive focus on Price

It is important that you choose an undervalued stock with good fundamentals. Focusing solely on low stock prices might not give you worthy investment opportunities.

Ignoring Debt

Highly leveraged companies are very risky. During distress, they are bound to struggle, even if their stock prices are low. This is because they have to repay the debt whether or not they make profits.

Chasing quick gains

Don’t go on chasing fast profits. It will only lead you into deeper pitfalls. Value investing is the game of patience. Make correct moves, and you can make a fortune.

Also Read: Top Stock Market Indicators Every Investor Should Follow

Tools and Resources for Value Investors

If you want to identify undervalued stocks in India, you can use various online portals that provide important information readily. Here are some of the best resources for your stock research:

Money Control

Arguably, money control is the best portal to find undervalued stocks in India. You can find diverse and comprehensive data for any company on this portal. Metrics like financial statements, ratios, market sentiment, etc, are readily available on this portal.

ET Money

You can follow ET Money for financial news to keep up with the developments in the stock markets. It will help you gauge how the market might react in different scenarios.

Screener.in

It is a powerful tool for screening undervalued stocks. You can run through various financial metrics and find the best stock for investment.

Yahoo Finance

You can find resources relating to global news and stock analysis on Yahoo Finance. It also provides the latest news and financial data. Alternatively, you can also use Google Finance.

Conclusion: Embracing the Value Investing Mindset

Unlike traders who look at the stock markets myopically and rely on short-term trends for profits, value investing is about growing wealth by staying invested. Remember, if you identify undervalued stocks correctly and the company has strong fundamentals, the opportunity is definitely up for grabs.