If a trader finds a stock that trades at a price that is different from its “fair” value, there is a chance for that trader to earn some profit. This is what you call an undervalued stock. What are undervalued stocks and how do you find them?
A Quick Definition of Undervalued Stocks
Undervalued stocks are stocks whose prices are lower than their real fair value. There are various reasons why a stock can be undervalued, such as how recognized the company is, market crashes, and negative press. The main assumption of fundamental analysis is that over time, the market prices are going to be correct enough to reflect the fair value of an asset and create profit opportunities.
Looking for an undervalued stock is not all about searching for the cheapest stocks you can find. The secret here is to scour for quality stocks with prices that are below their fair values instead of useless stocks at extremely low prices. The only difference is that stocks that are of good quality will increase in value after a long time. Most investors and traders love to copy the strategy of Warren Buffett, which is about looking for undervalued stocks and stocks with growth potential in the long run.
It is important to always collect the right financial details regarding a stock you want to trade and not just make your decisions according only to personal opinions.
Why are There Undervalued Stocks?
There are different reasons why a stock can become undervalued. These include the following:
- Market changes – Corrections or crashes in the market can cause a drop in the stock prices.
- Unexpected bad news – Undervalued stocks can occur because of negative prices or social, political and economic changes.
- Misjudged results – If a stock doesn’t perform as expected, it might affect its price.
- Cyclical fluctuations – Stocks in some industries perform poorly during certain quarters that can affect the share prices.
How Traders Look for Undervalued Stocks
In order to find an undervalued stock, traders make use of technical and fundamental analysis. The fundamental analysis method evaluates an asset’s value through a study of external influences and events as well as industry trends and financial statements. Technical analysis, on the other hand, examines and predicts price movements with the use of historical statistics and charts.
It is generally recommended for traders to use the two methods together when looking for undervalued stocks since this can give them the most complete overview of the market as a whole.
There are several primary ratios forming part of the fundamental analysis traders must consider together with technical analysis. Investors and traders commonly use the following eight ratios as part of fundamental analysis to look for undervalued stocks and identify their real value:
- Debt-equity ratio
- Price-to-earnings ratio
- Return on equity
- Dividend yield
- Earnings yield
- Price-to-book ratio
- Price-earnings to growth ratio
- Current ratio
Go through these eight ratios first when trading undervalued stocks. The main goal here is to look for shares with ratios that are different from that of industry norms. Take note that while these are useful ratios, they must form only a part of the fundamental analysis. In turn, you need to combine it with comprehensive technical analysis to get a complete market view.