People from all sects of society do online stock trading, but only some of them can build substantial grounds and earn extraordinary gains from their investments. If you wish to buy stocks at cheaper rates and sell them with huge profits, you need to do the necessary exercises to identify such undervalued stocks.

But, how to find undervalued stocks in India?

This article talks about the steps to figure out whether a stock is undervalued or not. Here are the 4 steps that you should follow in selecting the best stocks to invest in.

Financial Statements

  • 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.
    1. Assets: Assets owned by a company are utilised to generate future cash flows. The income generated thereof helps the business to pay out the liabilities.
    2. 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
  • 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 more attractive to investors.
    1. Revenue: The income earned by a company by selling its products and services is called revenue. For Ex: The revenue of Power Finance Corporation in 2021 was USD 9.5 billion (INR 71,700 Crores).
    2. Total Expenses: Total expenses include operating expenses, financing expenses, and taxation.
    3. Net Profit Margin: The prices of a stock having a higher net profit margin is more attractive for investors.
Net Profit = Revenue – Total Expenses
Net Profit Margin = Net Profit ÷ Revenue
  • Cash Flow Statement: There are 3 parts of a Cash Flow Statement. A company performing very well will have higher operating cash flows. Hence, stocks with better operating cash flows are attractive for investors.

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

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 against its peers, it is a must-buy!

For example: 

REC Ltd. P/ESector Average P/E
2.544.50

Ratio Analysis

Analysing the key ratios of a stock is another popular way to make your investment decision.

  • 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)
  • P/B Ratio: This ratio shows how many times of book value per share do investors want to pay.
P/B Ratio = Current Market Price ÷ Book Value Per Share (BVPS)
  • 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
  • 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 are a great opportunity to make planned investments with big returns however, it is important to conduct some research before you invest so as to protect your capital from eroding. By studying the above points, you can easily decide whether you should invest in stocks.

Happy Investing😇

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