Undervalued stocks exist in the stock market and can be a great opportunity to make higher returns. Understanding why and knowing how to spot undervalued stocks are the keys to capturing these returns. Read on to learn how you can capitalize on undervalued stocks and to understand why these mispricings can occur.
Why is a Stock Undervalued?
A stock can be undervalued for a number of reasons, and the answer to why it happens isn’t always clear cut. Understanding the different scenarios that can cause stocks to be undervalued will help you to better identify them.
- Overall Poor Market Conditions
Poor economic and market conditions can be a common factor as to why stocks are undervalued. Deteriorating economic conditions have an overall negative effect on the stock market as well.
As economic conditions worsen, uncertainty and pessimism rise, making investors more likely to pull out of their current market conditions. When large volumes of a stock are sold, it causes stock prices to decrease. The drop is not necessarily because the value of that company is actually decreasing but because of the relationship between volume and share prices. When economic conditions worsen, it may be an opportunity for investors to find mispriced and undervalued stocks which they will be able to purchase at a discount.
- Underdogs
Sometimes a lesser-known company shows strong growth in revenue, sales, and other key financial metrics, but its stock price seems to stay stagnant. While fundamentally the company is strong, it can be overlooked by investors because it might be newer, have lower brand recognition or is yet to be discovered.
For this reason, its share price remains lower than what it should be given the demonstrated growth. Companies like this can be the perfect opportunity for value investors to buy in at a cheaper price, as the stock price has the ultimate potential to catch up to the actual intrinsic value of the company.
- Cyclical Companies
Companies in certain industries or with certain business models are cyclical since their sales and revenues occur in a cycle and certain metrics are stronger during certain parts of the cycle. Examples of cyclical industries include luxury goods and airlines. Generally, the revenues of cyclical companies will be higher during times of economic growth and prosperity and will suffer during economic contraction.
Stocks of cyclical companies may be undervalued from worsening economic conditions rather than their actual intrinsic value decreasing. This situation can be good as it presents a buying opportunity for investors who are willing to ride the cycle and wait for the share prices to go up when economic conditions get better. Rather than the stocks being undervalued because the value of the firm is worsening, cyclical companies’ stocks will move based on consumer demand.
- Bad Press
Another common reason for a stock to become undervalued is from bad press. When negative reports about a company are published, it can instill fear and pessimistic thoughts in an investor’s head, causing them to sell their position in a company. When enough investors let bad press get to them and they sell their holdings, it can negatively impact stock prices.
Depending on what the bad press was, typically stock prices will bounce back. Bad media coverage usually affect share prices in the short term and isn’t an indication of complete downfall. As an investor, you will need to assess the situation and determine if you believe the company is strong enough to overcome the crisis or not. If you believe that the company can overcome whatever bad news was released, then that would present an opportunity for you to invest at a cheaper price.
What is Value Investing?
Value investing is a strategy famed by the iconic investor Warren Buffett. This strategy focuses on identifying stocks that are trading for less than what the intrinsic value says they should be traded for. By investing in quality stocks that you believe the market is underestimating, there is large potential for them to grow and provide solid returns.
This investment strategy focuses on the long term and is more of a passive investment strategy. Value investors rely on financial analysis to determine what the true intrinsic value of a company is to determine whether the market is underestimating that stock or not.
Should You Buy an Undervalued Stock?
Undervalued stocks hold the potential to yield solid returns, given that an investor has properly analyzed the factors causing that stock to not be accurately priced. For example, if a stock is undervalued from bad press or a bad quarter but the intrinsic value of the underlying business says the stock price is undervalued, it could be a good investment to make. On the other hand, if you believe a stock is undervalued because of internal problems within the firm, chances are that stock does not have good potential for growth and is not a good investment.
Are Undervalued Stocks Volatile?
Volatility and underestimated stock prices aren’t distinctly correlated. However, oftentimes, both undervalued stocks and highly volatile stocks are associated with companies that investors believe to be in trouble.
For example, when a company faces uncertainty about its future, its volatility will probably increase. This happens because investors are not able to wholly determine whether or not to invest in that security. Furthermore, when stocks are undervalued, the market’s perception of a security is not accurately reflecting the true book value of that firm. This factor may indicate that investors are pessimistic about that company.
Frequently Asked Questions
Is it good if a stock is undervalued?
As an investor looking to buy, it can be good if a stock is undervalued as it allows them to buy in at a cheaper price with room for potential growth.
How do you know if a stock is undervalued?
By finding the intrinsic value of a company and then dividing it by the number of outstanding shares, you will be able to determine the correct pricing of a stock. If your valuation says the stock price is above what it is currently trading for on the market, that means the stock is undervalued.