Damon Mcknight
Undervalued stocks are those with a price lower than their real or 'fair' value. Stocks can be undervalued for various reasons, including negative press, economic, political and social changes, and market crashes. Traders use fundamental and technical analysis to find undervalued stocks. Fundamental analysis involves evaluating the value of an asset by studying external events and influences, financial statements, and industry trends. Technical analysis involves examining and predicting price movements using historical charts and statistics. A popular metric used in fundamental analysis is the P/E ratio, which compares the price per share to the earnings per share. A low P/E ratio could indicate that a stock is undervalued. By investing in undervalued stocks, investors can take advantage of market inefficiencies and potentially achieve long-term growth and capital gains.
| Characteristics | Values |
|---|---|
| Undervalued stock definition | A stock with a price that is lower than its real or 'fair' value |
| Reasons for stocks being undervalued | Negative press, economic/political/social changes, cyclical fluctuations, misjudged results, recognisability of the company, market crashes |
| Finding undervalued stocks | Fundamental analysis, technical analysis, and eight commonly used ratios |
| Fundamental analysis | A method of evaluating the value of an asset by studying external events, financial statements, and industry trends |
| Technical analysis | Examining and predicting price movements using historical charts and statistics |
| Popular ratios | P/E ratio, calculated by dividing the price per share by the earnings per share |
| Example of undervalued stock | BHP, with a P/E ratio of 6.5, compared to the ASX 200's P/E ratio of 27.99 |
| Example of undervalued stocks with a P/E ratio of less than 15 | Woodside Energy (P/E ratio of 7.41), FSA Group (P/E ratio of 7.8), National Australia Bank (P/E ratio of 14.86) |
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What You'll Learn
Negative press, economic changes, and cyclical fluctuations
Negative press can cause stocks to become undervalued. This can be sudden bad news, such as negative press or economic, political, and social changes. For example, a company might receive negative press for its involvement in a scandal, or for making controversial statements.
Economic changes can also cause stocks to become undervalued. This could include market crashes or corrections, which can cause stock prices to drop. For example, the Global Financial Crisis of 2008 caused a significant drop in stock prices worldwide.
Cyclical fluctuations refer to the performance of certain industries' stocks, which may be poor during certain quarters, affecting share prices. For example, retail stocks may perform poorly during the lead-up to the holiday season, as people are more likely to spend their money on gifts and experiences rather than on the products of a specific company.
It's important to note that finding undervalued stocks is not just about finding cheap stocks. It's about looking for quality stocks at prices under their fair values, which have the potential to grow over the long term.
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Fundamental analysis and its eight ratios
Traders and investors use fundamental analysis to evaluate the value of an asset by studying external events and influences, financial statements, and industry trends. This type of analysis is combined with technical analysis to identify undervalued stocks.
Fundamental analysis involves the use of several ratios, with the P/E ratio being the most popular. This ratio indicates how much one would have to spend to make $1 in profit. A low P/E ratio could mean that stocks are undervalued. The P/E ratio is calculated by dividing the price per share by the earnings per share (EPS). EPS is calculated by dividing the total company profit by the number of shares issued.
- PEG ratio: This ratio considers the P/E ratio in relation to the company's expected earnings growth rate. A lower PEG ratio indicates that the stock is more undervalued relative to its expected growth.
- Price-to-sales ratio: This ratio compares a company's stock price to its revenue, providing a measure of value that is not influenced by profitability. A lower ratio may indicate that the stock is undervalued.
- Price-to-book ratio: This ratio compares a company's stock price to its book value, which includes both tangible and intangible assets. A lower ratio may suggest that the stock is undervalued.
- Dividend yield: This ratio calculates the percentage of annual dividends paid out relative to the stock price. A higher dividend yield may indicate that the stock is undervalued.
- Return on equity (ROE): This ratio measures a company's profitability by evaluating how much profit it generates from shareholders' investments. A higher ROE indicates greater profitability and potential undervaluation.
- Debt-to-equity ratio: This ratio compares a company's total liabilities to shareholders' equity, providing insight into its financial leverage. A lower ratio may indicate a stronger financial position and potential undervaluation.
- Current ratio: This ratio assesses a company's ability to meet its short-term obligations by comparing current assets to current liabilities. A ratio greater than 1 indicates that the company can cover its short-term debts, suggesting financial stability and potential undervaluation.
It is important to remember that these ratios should be considered in conjunction with other analysis methods and that a 'good' ratio will vary across industries and sectors due to differing competitive pressures.
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Technical analysis and historical charts
Technical analysis is a method of examining and predicting price movements using historical charts and statistics. It involves studying past market data, including price and volume, to identify trends and understand possible future price movements. By analysing charts and using technical indicators, investors can gain insights into a stock’s behaviour and identify potential opportunities.
A widely used subset of technical analysis is trend following, which operates on the belief that trends persist over time. By following trends, investors can identify opportunities to buy undervalued stocks before they reach their true value. For example, investors can look for stocks that are turning higher after a period of poor performance, as this can be a sign that the trend is changing from down to up, and this is often a point of undervaluation.
To identify these trends, investors often use technical analysis tools such as moving averages, trend lines, and momentum indicators. These tools can help identify key levels of support and resistance in the market, as well as potential entry and exit points. For instance, the Relative Strength Index (RSI) is a popular indicator used to identify overbought or oversold conditions in the market. It oscillates between 0 and 100, with values above 70 typically considered overbought and values below 30 considered oversold.
Additionally, algorithms can be used to quickly scan the market and identify undervalued stocks that meet certain criteria, such as those that are starting to trend above their moving averages and have broken to a new high. Websites like Market Index provide technical analysis through charts and scans of stocks, allowing investors to easily catch trends, reversals, or potential breakouts.
While technical analysis is a valuable tool, it should be noted that no indicator can guarantee a successful trade. It is important for traders to conduct thorough analysis and risk management before making any investment decisions. Combining technical analysis with fundamental analysis, which involves evaluating a company's financial health and growth prospects, can provide a more comprehensive understanding of the market and potential investment opportunities.
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Relative Strength Index and price instability
The Relative Strength Index (RSI) is a popular technical indicator used to identify undervalued stocks in Australia and is available on most trading platforms. It is a momentum oscillator that measures the speed and magnitude of a security's recent price changes to detect overbought or oversold conditions. The RSI is displayed as an oscillator (a line graph) on a scale of zero to 100. An RSI above 70 indicates that a stock is overbought and may be due for a trend reversal, signalling investors to sell. On the other hand, an RSI below 30 indicates that a stock is oversold and may be due for an upward trend reversal, signalling investors to buy.
The RSI was introduced in 1978 by J. Welles Wilder Jr. in his book, "New Concepts in Technical Trading Systems". It is a valuable tool for traders as it provides signals about bullish and bearish price momentum and can indicate when a stock may be primed for a trend reversal or a corrective pullback in price. The RSI works best in trading ranges rather than trending markets, and it is important to note that the RSI should be used in conjunction with other technical indicators for a more comprehensive analysis.
Traders and investors can benefit from using the RSI to identify oversold stocks and anticipate future rebounds, allowing them to take advantage of price instability. By studying price charts and utilising the RSI, they can identify buy and sell signals and make more informed investment decisions.
It is important to remember that the RSI has its limitations and may not always provide accurate signals, especially in strong upward or downward trends. Therefore, it should be combined with other indicators and analysis methods, such as fundamental analysis, which evaluates external events, financial statements, and industry trends, to get a full view of the market and make more informed investment decisions.
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Fair value metrics and financial modelling
A key tool for finding undervalued stocks is fundamental analysis, which involves evaluating the value of an asset by studying external events and influences, financial statements, and industry trends. Within fundamental analysis, financial ratios are used to help analyse a company's fundamentals. One of the most popular ratios is the price-to-earnings (P/E) ratio, which measures how much an investor would have to pay for each dollar in profit. A low P/E ratio could indicate that a stock is undervalued. The P/E ratio is calculated by dividing the price per share by the earnings per share (EPS), which is itself calculated by dividing the total company profit by the number of shares issued.
Other important financial ratios for identifying undervalued stocks include the price-to-book ratio (P/B ratio), which measures whether a stock is over or undervalued by comparing the net value of a company to its market capitalization. The P/B ratio is calculated by dividing a stock's share price by its book value per share (BVPS). Another ratio is debt-to-equity, which measures a company's financial leverage and indicates how much debt a company is using to finance its assets.
Advanced financial modelling can also be used to predict a stock's potential market price by looking at future cash flows, similar to the methods used by investment banks and equity research firms. These models use data from trusted sources like S&P Global Market Intelligence to make predictions about a stock's fair value. By combining fair value metrics with financial modelling, investors can identify undervalued stocks in Australia and take advantage of potential investment opportunities.
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