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How to Identify Undervalued Stocks?

Online stock trading is slowly but steadily becoming popular in India due to the ease of access and high returns. That’s why traders and investors are always on the lookout for the next big thing aka undervalued stocks while trading online. 

Turns out, undervalued stocks may present themselves as an opportunity to make potentially big gains. However, finding undervalued stocks and more importantly, ones that have the potential to do well can be difficult.

How to Identify Undervalued Stocks in India?

An undervalued stock, by definition, is a share that trades below its true value or intrinsic value. These stocks are available at a discounted price and may have the scope to generate better returns in the future.

Let’s discuss some of the well-known steps that are used to figure out whether a stock is undervalued or not.

1. Evaluate Financial Statements

A financial statement tells you the worth of a company and whether or not it is making money. You can dig deeper into the balance sheet of the company to know whether its stock is undervalued.

1. Balance Sheet

It shows the assets and liabilities of a company at the end of a financial year. The valuation of a company depends on its net worth.

  • Assets: Assets owned by a company are utilized to generate future cash flows. The income generated thereof helps the business to pay out the liabilities.
  • Liabilities: A business borrows money in the form of debt or shareholder’s funds. These liabilities need to be paid off by the business.
Net Worth = Assets – External Liabilities

2. Statement of Profit & Loss

This statement shows the revenue and expenses of a company during a financial year. A company having a higher net profit is known to be more attractive to investors. These are the components of a Profit & Loss statement: 

  • Revenue: The income earned by a company by selling its products and services is called revenue. For example, the revenue of Power Finance Corporation in 2021 was USD 9.5 billion (INR 71,700 Crores).
  • Total Expenses: Total expenses include operating expenses, financing expenses, and taxation.
  • Net Profit Margin: The prices of a stock having a higher net profit margin may be more attractive to investors.
Net Profit = Revenue – Total Expenses
Net Profit Margin = Net Profit ÷ Revenue

3. Cash Flow Statement

There are 3 parts of a Cash Flow Statement:

  • Operating activities
  • Financial activities
  • Investments

A company performing very well will have higher operating cash flows. Hence, shares of companies with better operating cash flows can be attractive to investors.

2. Discounted Cash Flows (DCF)

Under the DCF model, it is assumed that the current market price is a reflection of the present value of future cash flows of a business. If the current market price of a stock is less than the DCF value, it is a must-buy!

DCF = Future Cash Flows ÷ Discounting Rate
  • Assumptions in this method
    1. Future Growth Rates
    2. Cost of Funds
    3. Discounting Rates

3. Peer Comparison

Industry peers have similar operating environments and processes. Hence, it is fair to compare them. A widespread practice among investors is to compare the financials of a stock with its peers and industry averages. If a stock is priced cheaper but has better financials than its peers, it is a must-buy!

For example: 

REC Ltd. P/ESector Average P/E
2.544.50

4. Ratio Analysis

Analyzing the key ratios of a stock is another popular way to make your investment decision. You can pick a classic ratio like P/E that can help you understand whether a stock is undervalued or not.

1. P/E Ratio

The price-to-earnings ratio shows how many times the earnings the investor wants to pay for a stock. PE Ratio is one of the metrics to identify undervalued stocks.

P/E Ratio = Current Market Price ÷ Earnings Per Share (EPS)

2. P/B Ratio

This ratio shows how many times of book value per share investors want to pay.

P/B Ratio = Current Market Price ÷ Book Value Per Share (BVPS)

3. ROE

Return on Equity is a key indicator for investors. Investors are willing to pay more for a high ROE stock.

ROE (%) = Net Income ÷ Shareholder’s Equity

4. ROCE

Return on Capital Employed indicates how many times the earnings cover the liabilities of a company, including debt and equity.

ROCE = Earnings Before Interest and Taxes (EBIT) ÷ Capital Employed

Takeaway

Undervalued stocks may be a great opportunity to make planned investments with big returns. However, it is important to conduct thorough research before you invest. 

The pointers above can serve as a guide to some of the factors you should look at when you invest in stocks that are undervalued.

📌 You can also read:

Happy Investing😇

Disclaimer: This blog is not to be construed as investment advice. Trading and investing in the securities market carries risk. Please do your own due diligence or consult a trained financial professional before investing.

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Ashish Thakur

I am all about good food, music and investments.

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