An undervalued stock is defined as a
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
that is selling at a price significantly below what is assumed to be its
intrinsic value. For example, if a stock is selling for $50, but it is worth $100 based on predictable future cash flows, then it is an undervalued stock. The undervalued stock has the intrinsic value below the investment's true intrinsic value.
Numerous popular books discuss undervalued stocks. Examples are ''
The Intelligent Investor
''The Intelligent Investor'' by Benjamin Graham, first published in 1949, is a widely acclaimed book on value investing. The book provides strategies on how to successfully use value investing in the stock market. Historically, the book has been ...
'' by
Benjamin Graham, also known as "The Dean of Wall Street," and ''
The Warren Buffett Way
''The Warren Buffett Way'', a book by author Robert Hagstrom, which outlines the business and investment principles of value investing practiced by American businessman and investor Warren Buffett
Warren Edward Buffett ( ; born August 30, 1 ...
'' by Robert Hagstrom. ''The Intelligent Investor'' puts forth Graham's principles that are based on mathematical calculations such as the
price/earning ratio. He was less concerned with the qualitative aspects of a business such as the nature of a business, its growth potential and its management. For example, Amazon, Facebook, Netflix and Tesla in 2016, although they had a promising future, would not have appealed to Graham, since their price-earnings ratios were too high. Graham's ideas had a significant influence on the young
Warren Buffett
Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net ...
, who later became a famous US billionaire.
Determining factors
Morningstar uses five factors to determine when something is a value stock, namely:
* price/prospective earnings (a predictive version of
price/earnings ratio sometimes called Forward P/E.)
*
price/book
*
price/sales
*
price/cash flow
*
dividend yield
The dividend yield or dividend–price ratio of a share is the dividend per share, divided by the price per share. It is also a company's total annual dividend payments divided by its market capitalization, assuming the number of shares is constant ...
Warren Buffett
Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net ...
, also known as "The Oracle of Omaha," stated that the value of a business is the sum of the cash flows over the life of the business discounted at an appropriate interest rate.
Warren Buffett's 1989 letter to Berkshire Hathaway shareholders
/ref> This is in reference to the ideas of John Burr Williams
John Burr Williams (November 27, 1900 – September 15, 1989) was an American economist, recognized as an important figure in the field of fundamental analysis, and for his analysis of stock prices as reflecting their " intrinsic value".
He is ...
. Therefore, one would not be able to predict whether a stock is undervalued without predicting the future profits of a company and future interest rates. Buffett stated that he is interested in predictable businesses and he uses the interest rate on the 10-year treasury bond in his calculations. Therefore, an investor has to be fairly certain that a company will be profitable in the future in order to consider it to be undervalued. For example, if a risky stock has a PE ratio
Pe may refer to: Physical education
Language
* Pe language
* Pe (Cyrillic), a letter (П) in the Cyrillic alphabet
* Pe (Semitic letter), a letter (פ ,ف, etc.) in several Semitic alphabets
** Pe (Persian letter), a letter (پ) in the Arabic al ...
of 5 and the company becomes bankrupt, this would not be an undervalued stock. Some qualities of companies with undervalued stocks are:
# The company's earning history is stable.
# The company does not specialize in high-technology that can become obsolete overnight.
# The company is not in the middle of some financial scandal.
# The company's low PE ratio is not due to profits realized from capital gains.
# The company's low PE ratio is not due to a major decline in profitability.
# The company's PE ratio is below its average PE ratio for the last 10 years.
# The company is selling at a price below its tangible asset value.
# The company's trailing 3-years earnings has risen over the past 10 years.
# The company's credit rating is AAA, AA, or A, or even better, there is no rating because there is no debt at all.
# The company did not have a loss during the last recession.
# The company's PEG ratio The 'PEG ratio' ( price/earnings to growth ratio) is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share ( EPS), and the company's expected growth.
In general, the P/E ratio is ...
is low. A Price/Earnings/Growth rate below 1 means the PE ratio is less than the growth rate.
An excellent stock at a fair price is more likely to be undervalued than is a poor stock at a low price, according to Charles Munger
Charles Thomas Munger (born January 1, 1924) is an American billionaire investor, businessman, and former real estate attorney. He is vice chairman of Berkshire Hathaway, the conglomerate controlled by Warren Buffett; Buffett has described Mung ...
, the Harvard-educated partner of Buffett. An excellent stock continues to rise in value over the long term, while a poor stock declines in value. An undervalued stock will usually have a low PE ratio. For example, a PE ratio of 10 is much better than a PE ratio of 20. Some high-flying Internet stocks had PE ratios of 30, 40, 50, 100, 200 or more in year 2000, prior to the bursting of the Internet stock bubble. Investors of these Internet stocks did not purchase undervalued stocks, as they later learned.
See also
*Stock valuation
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit fr ...
*Value investing
Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham ...
*Penny stock
Penny stocks are common shares of small public companies that trade for less than one dollar per share.
The U.S. Securities and Exchange Commission (SEC) uses the term "Penny stock" to refer to a security, a financial instrument which represents a ...
*Multibagger stock
A multibagger stock is an equity stock which gives a return of more than 100%. The term was coined by Peter Lynch in his 1988 book ''One Up on Wall Street'' and comes from baseball where "bags" or "bases" that a runner reaches are the measure of t ...
References
{{reflist
Valuation (finance)
Stock market
Investment
Business terms
Mathematical finance
Finance theories