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How to Identify and Trade Undervalued Stocks

The main trader’s philosophy is to buy something cheap and sell it at a higher price. This is actually how any financial market works. Investors usually apply the same principles when focusing on short-selling stocks.

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The idea is quite simple. You look for a cheaper stock and sell it at a higher price to make a profit. The only challenge here is to find this kind of asset. Mostly, undervalued stocks are pretty hard to identify, especially when it comes to beginners in the stock market.

In this article, we will discuss simple ways to find and analyse them as well as several easy tips to trade undervalued assets and stocks in particular.

Undervalued Stocks Meaning

When we say “an undervalued stock”, we generally mean an asset with a price lower compared with the intrinsic value. Imagine a company with around $1 billion in free cash generated annually with a $1.5 billion market cap. It is obvious that it is undervalued.

Oppositely, if we consider the same company with a market cap of $50 billion, we can say it is overvalued. It will take it 50 years to generate enough free cash flow to cover that cap.

Generally, long-term investors prefer buying undervalued stocks expecting them to rise in price. The strategy is also known as value investing. These assets will not suit day traders, as it may take much time for undervalued stocks to grow in price.

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Factors that Make Stock Get Undervalued

The main idea behind the efficient market theory considers a company’s stock price to reflect the financial information about it. In simpler words, the market cap provides investors with fundamental financial data.

Industries

Sometimes, stocks get undervalued because the issuing company is focused on a single market sector and ignores other industries. For instance, a company was paying attention mainly to stock growth during the past decade instead of considering the natural resource sector (gas and oil, for example). As a result, energy stocks went undervalued.

Performance

Secondly, underperformance is another reason for stocks to get undervalued. Imagine an asset issued by the company that has been delivering weak annual or quarterly results. Investors are likely to sell these stocks, which will also result in a price decline.

Macro

Last but not least, different macro factors can also be the reason for an undervalued asset. When the FED hikes the interest rate, shares will become cheaper. The same happens in case of different geopolitical issues taking place globally. Even bad news about the company’s poor management can result in a stock price decline.

How to Identify an Undervalued Stock?

Investors can apply two major strategies that will let them decide if the underlying asset is undervalued or not.

Multiple Analysis

This type of analysis is the easiest way to identify an undervalued stock. The idea behind the method is quite simple. One is supposed to compare and contrast several multiples of other companies alike from the same sector or industry.

The multiples to consider are as follows:

  1. PE. Price-to-earnings is used to compare current stock prices with past and future earnings. If the PE ratio is low, we can say the company is undervalued.
  2. PS. Price-to-sales is the method based on comparing the stock price with the company’s overall sales. However, some investors ignore this technique, as they are mainly interested in what a company earns.
  3. EV to EBITDA. The method compares the overall company’s enterprise value with its EBITDA. Most experienced investors use it as the main tool to measure the valuation of the underlying company.
  4. Price to free cash flow. A baseline method to compare the stock value with the generated free cash flow.

DCF (Discounted Cash Flow)

DCF is another strategy used to define an undervalued stock. It is a complex approach that takes much time to implement. The idea is to measure the company’s valuation backed by its potential cash flow generated in the future.

Tips to Find Undervalued Stocks

Today, even beginners will find it easy to detect undervalued stocks. The [process has become simpler thanks to companies and online services like Yahoo Finance, as they provide free screeners and major indicators to measure the asset value.

A screener is a trader’s tool that lets you easily compare different companies based on fundamental metrics including those we have mentioned earlier. So, if you want to find stocks that are undervalued, you need to look for the following:

  • Assets that lagged behind the peers and market – the idea is to find trusted and reliable companies of high quality with shares that have dropped drastically over the last few months.
  • Low Multiples – another strategy is to find companies with relatively lower multiples for earnings and sales.
  • Catalyst – a good thing to find a company with a low stock price and catalyst to push the price higher in the long run.
  • Dividend yield – identify companies that provide high dividend yields, as they can be also undervalued.

The Bottom Line

Undervalued stocks can be a cheaper and simpler way to enter the market with lower capital and the potential to make a good profit further. The main challenge here is to find assets that will eventually grow in value. This is where most beginners may face some difficulties.

Luckily, with modern online services and time-tested methodologies, traders will find it easy to identify and trade undervalued stocks. Just make sure you do not apply those strategies together with the day trading approach. They work only for long-term investments.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.