Hunting for Gains from Investing in Undervalued Sectors/stocks

A financial security or other types of investment that is selling for a price presumed to be below the investment's true intrinsic value. A undervalued stock can be evaluated by looking at the underlying company's financial statements and analyzing its fundamentals, such as cash flow, return on assets, profit retention an capital management, to determine said stock's intrinsic value.  Buying stocks when they are undervalued is a key component of Warren Buffet's value investing strategy. There is no guarantee as to when or whether a stock that appears undervalued will appreciate. There is also no single correct way to determine a stock's intrinsic value - it is basically an educated guessing game. 

Valuation Measures for Finding Undervalued Sectors/stocks

1. Price-Earning (P/E) Ratio: 

• The price earning ratio is a valuation measure that indicates how much the market values per Rupee or Dollar of earning of a company. 
• It is computed as: (Market Price of Share/ Earning per share)
• PE is represented as a multiple. When one refers to a stock as trading at 12x, it means that stocks is trading at 12 times its earnings. The PEx based on historical earnings is of limit value. The prices change dynamically, while the reported earning is updated every quarter. Therefore, prices tend to move even after the historical earning per share is known, in anticipation of the future earnings. 
• It is common to look at the PE multiple of the index to gauge if the market is overvalued or undervalued. The PE multiple moves high when prices run ahead of the earning numbers and the market is willing to pay more and more per amount of earning.
• Many would consider a market PE of 25x or above as an overvalued zone. When markets correct and uncertainty about future earnings increases, the PE multiple also drops. A value investor, who would like to pick up stocks when they sell at lower valuations, may be interested to purchase when PE is low. 

2. Dividend Yield: 

• Value investors, who look for the opportunity to buy a stock at a price lower than its fundamental or intrinsic value, prefer a combination of law PE, low PBV and high dividend yield. 
• Dividend yield compares the dividend per share to market price per share. 
• A higher dividend yield would mean that the income potential of the share is not yet reflected in the market prices. A lower dividend yield is associated with a higher valuation for a share.  It also used as broad levels with which to measure market cycles. 
• A bull market will be marked by falling dividend yields, as prices move up. A bear market will have a relatively higher and increasing dividend yield as prices tend to fall. 

3. Price to Book Value (PBV): 

• The PBV ratio compares the market price of the stock with its book value. It is computed as market price per share upon book value per share. The book value is the accounting value per share, in the books of the company. 
• It represents the net worth per share. An important limitation of this number is that most assets on the books of the company are shown as cost less depreciation, and not inflation adjusted. Therefore the realizable value of the assets is not reflected in the book value. 
• If the market price of the stock were lower than the book value, the stock is deemed to be undervalued and undiscovered. Analysts would concur that the market prices have fallen more than what is justified by the value of the stock, and would consider the price attractive to buy. 
• In a bullish market when prices move up rapidly, the PBV would go up, indicating rich valuation in the market. However, there may be other reasons for a stock being sold for less than its book value such as the poor investments made by the firm in the past which needs to be written down subsequently. 
• Hence investors should not rely only on PBV for their investment decision and should understand that not all stocks that trade at a discount on their book values are bargains (under-valued). 

4. Net Cash Flow: 

• It is the cash flow which is left after all necessary cash outflows have been deducted. These cash outflows include both operating expenses & capital expenditure.  It is a primary determinant of whether a company's stock is undervalued or not. In case, a company possesses net or free cash flow, it has the financial capacity to invest in R&D, paying existing debts, launch new products, provide timely dividends to shareholders etc.  
• Some qualitative fields based on which it is determined whether the stock of a company is undervalued or not are –
• The earning history of a company. 
• A company is not indulged in any financial scam. 
• the products offered by a company and whether such products have the potential to sustain and be profitable in the future. 
• A company's credit rating which denotes its debt-reliance. 
• A company's profit or loss during the previous recession. 

Value investors analyse these fields and other related factors and metrics to determine whether the stock of a company is undervalued or not.

Who should Invest in Undervalued Shares? 

Undervalued stocks have considerable potential to yield substantial returns if investors can properly reckon and analyse the different variables which are related to such stocks. Besides, analyzing companies and its shares to determine whether each organisation’s earning potential shows promise in the future requires significant technical knowledge.

Value investors duly wait for market conditions which will render the market price of a stock below its intrinsic value. These investors follow the principle that if they can purchase a share at a discounted price, where they procure a similar product, why should they purchase it at its face value or higher.

Advantages of Undervalued Stock

⦁ Prices of undervalued stocks automatically return to their original value or intrinsic value, which is why profits are assured.

⦁    It presents an opportunity to purchase shares at low prices from well-established or promising companies.

⦁    These stocks also feature low risk due to the fact that such undervaluation is cyclical and the company has the potential to attain its intrinsic value.

Disadvantages of Undervalued Stock:

⦁ Every investor cannot decide to invest in such funds.

⦁ It is time-consuming.

⦁ Investors run the risk of flawed analysis.

Hence, investors should begin by investing in less risky financial instruments when they initially begin. For investors looking for short term gains these may not prove to be fruitful as undervalued stocks need time to show their true worth. However, if you are a patient investor who has done exhaustive research and believes in the fundamental soundness of the business, then investing in undervalued stocks could be a rewarding experience.