Investing in the stock market can be a thrilling yet complex endeavor. One of the key strategies for making informed investment decisions is understanding whether a stock is undervalued or overvalued. This knowledge can help investors buy low and sell high, maximizing their returns. Let’s dive into what these terms mean and how you can identify such stocks.
What Are Undervalued Stocks?
Undervalued stocks are those that are trading below their intrinsic value. The intrinsic value is an estimate of the stock’s true worth based on fundamental analysis, which considers various financial metrics and economic factors. When a stock’s market price is lower than its intrinsic value, it is considered undervalued. Investors often seek out these stocks because they have the potential to increase in value over time, offering a profitable investment opportunity.
What Are Overvalued Stocks?
Overvalued stocks, on the other hand, are those trading above their intrinsic value. This means the market price is higher than what the stock is fundamentally worth. These stocks are often driven by market hype, speculation, or temporary factors that inflate their prices. Investing in overvalued stocks can be risky, as their prices may eventually correct, leading to potential losses.
How to Identify Undervalued and Overvalued Stocks
To identify whether a stock is undervalued or overvalued, investors can use several financial metrics and analysis techniques. We suggest the following methods for valuing public limited companies.
- Asset Value of the Equity
Here we look into what the company owns, in terms of assets, and what the company owes, in terms of liabilities. We take most of the information we need from the balance sheet, but also make adjustments to the entries, and add entries that don't appear at all on the balance sheet. For instance, we account for the brand of companies, which won't appear on the balance sheet but carries economic value.
- Earnings Power Value of the Equity
Here, we account for what the company will earn over the lifetime of the business. We look into the present profitability of the business and discount the same profitability over the lifetime of the business.
We add all those future discounted cash flows together to find the intrinsic value.
- Growth
Here, we look at how much the business will grow over the coming years. First, we need to establish the present day return on invested capital. Then we find how much the business will be investing in its future, and take the present day return on invested capital to predict what future growth will look like.
Conclusion
Understanding the concepts of undervalued and overvalued stocks is crucial for making informed investment decisions. By using financial ratios and analyzing a company’s fundamentals, investors can identify potential investment opportunities and avoid overpaying for stocks. Remember, the goal is to buy low and sell high and recognizing undervalued and overvalued stocks is a key part of that strategy.
In this article, we value each business in the FTSE 100 periodically and show you which stocks are undervalued in our opinion.
This is not investment advice, but only meant to give you a steer on what companies may be of interest.