How to Identify Undervalued Stocks for the Long Term?

Investing in undervalued stocks has been a favoured strategy for seasoned investors. These stocks have the potential to get maximum returns while minimising the risks. These stocks are like hidden gems, and to find hidden gems, a lot of careful research, disciplined analysis and patience are required.

But worry not, this blog will guide you through the process of finding undervalued stocks, evaluating them for long-term potential, and avoiding common pitfalls. So, let's begin!

What are Undervalued Stocks?

At its core, an undervalued stock is one that trades below its intrinsic value. The intrinsic value represents the true worth of the company based on its financial performance, future potential, and other qualitative factors. If the market price of a stock is lower than its intrinsic value, it is considered undervalued.

Market Price vs Intrinsic Value

• Market Price: This is the current price at which the stock is trading in the market. It reflects investor sentiment, which can be influenced by short-term factors like news events or market trends. 
• Intrinsic Value: This is an estimate of the stock's fair value based on financial metrics such as earnings, cash flow, book value, etc. 

Let's understand with an example.

Suppose there’s a mid-sized manufacturing company, XYZ. The company’s intrinsic value, based on its consistent cash flow and growth potential, is estimated at ₹1000 rupees per share. However, due to a temporary supply chain issue that affects one quarter’s earnings, the stock’s market price drops to ₹700 per share. If the supply chain issue is resolved and the company returns to its normal operations, the market price could eventually rise to reflect its intrinsic value, rewarding patient investors who bought the stock at the undervalued price.

How Stocks Become Undervalued?

Stocks become undervalued for several reasons:

• Market Inefficiencies: Temporary factors, such as weak earnings in a single quarter, can cause a stock's price to drop below its intrinsic value.
• Negative Sentiment: Short-term news like legal issues or economic downturns, can refrain investors from buying a fundamentally strong stock. 
• Lack of Market Awareness: Smaller companies or lesser-known stocks may not attract much attention, even if they have strong fundamentals.

Why Invest in Undervalued Stocks?

There are two major reasons to invest in undervalued stocks: 

Margin of Safety

When you invest in undervalued stocks, you create a margin of safety. This means you’re less likely to experience significant losses during market downturns because the stock has a buffer between its intrinsic value and its market price.

Risk-Reward Balance

Undervalued stocks often offer a favourable risk-reward profile. If the stock is undervalued due to temporary issues, it has the potential to rebound as the market corrects itself. This can lead to significant long-term gains.

Examples of Successful Undervalued Stock Investments

Many legendary investors, such as Warren Buffett, have built their fortunes by identifying undervalued stocks. For example:

• Buffett’s investment in Coca-Cola during the late 1980s became one of his most iconic success stories. He purchased a significant stake when the stock was trading at a relatively low valuation compared to its intrinsic value, recognising the company’s global brand dominance and growth potential. Over time, the investment delivered extraordinary returns as Coca-Cola expanded and increased profitability.
• Similarly, during the 2008 financial crisis, many high-quality stocks were trading at a fraction of their intrinsic value, presenting incredible buying opportunities for long-term investors.

Key Indicators to Identify Undervalued Stocks

To determine whether a stock is undervalued, investors rely on several financial metrics. Here are some of the most commonly used indicators: 

Price-to-Earnings (P/E) Ratio

A low P/E ratio relative to industry peers or historical norms may indicate that a stock is undervalued. However, this must be analysed in conjunction with the company's growth potential and sector trends.

Price/Earnings to Growth (PEG) Ratio

The PEG ratio adjusts the P/E ratio by factoring in the company’s earnings growth rate. A PEG ratio below 1.0 often signals undervaluation, as it suggests the stock is cheap relative to its growth potential.

Free Cash Flow

Companies with strong and consistent free cash flow are often undervalued if their stock price is low relative to their cash generation potential. Free cash flow indicates the company’s ability to fund operations, pay dividends or reinvest in growth. DCF valuation model is widely used for such companies.

Revenue and Earnings Growth

A company with solid revenue and earnings growth that is trading at a low valuation may indicate future potential for price correction. This is especially true if the undervaluation is due to temporary factors rather than long-term issues. 

As a beginner, calculating the intrinsic value or fair value of a stock can be a daunting task. To make it easier, we have designed multiple valuation calculators. Check it out at ticker.finology.in

Steps to Analyze and Identify Undervalued Stocks for Long-Term Investment

To get the best out of undervalued stocks, you need to follow some steps before investing in them.

Step 1: Understand the Business Model and Industry Trends

Before getting into financial analysis, it's important to understand the company's business model and its position within the industry. Key questions to ask include:

• What is the company's core business?
• Is the industry growing or declining?
• Does the company have a competitive advantage or moat?

Step 2: Conduct Fundamental Analysis

Fundamental analysis involves evaluating key financial ratios and metrics. Some important steps include:

• Examine Key Ratios: Analyze P/E, P/B (Price-to-Book), and P/S (Price-to-Sales) ratios.
• Compare with Peers: Look at how the company’s valuation compares to industry benchmarks.
• Review Historical Performance: Assess the company’s past revenue, earnings, and cash flow trends.

Step 3: Evaluate Qualitative Factors

Quantitative analysis is not enough; you also need to consider qualitative factors such as:

• Management Quality: Is the leadership team experienced and reliable?
• Corporate Governance: Does the company follow ethical business practices?
• Competitive Advantages: Does the company have patents, brand recognition, or other unique strengths?

Step 4: Analyze Macro-Economic and Sector Trends

Understand how broader economic conditions and sector-specific trends might impact the company’s long-term prospects. For example:

• Are there regulatory changes affecting the industry?
• How does the company perform during economic downturns?

Common Mistakes to Avoid When Selecting Undervalued Stocks

Identifying undervalued stocks can be rewarding, but it’s important to navigate the process carefully to avoid common pitfalls.

Mistake 1: Ignoring Industry and Sector Trends

Failing to consider industry-wise issues can lead to poor investment decisions. For example, a company in a declining industry might appear undervalued but could face long-term challenges. 

Mistake 2: Overvaluing Low P/E or P/B Stocks 

Low valuation ratios can sometimes indicate underlying problems with the business. Always analyse these ratios in conjunction with other factors like earnings quality and growth prospects.

Mistake 3: Focusing on Short-term Fluctuations

Don’t get distracted by temporary market noise. Instead, focus on the company’s intrinsic value and long-term potential. 

Mistake 4: Ignoring the Importance of Diversification

Investing too heavily in a single stock can expose you to unnecessary risk. Diversification helps mitigate this risk by spreading your investments across different sectors and industries.

Mistake 5: Wrong Assumptions

Just like in coding, valuation too follows the principle of “Garbage In, Garbage Out.” A number of estimates go into building any valuation model like growth rate, cost of capital, expected earnings multiple, etc. Any bluff or miscalculation of these rates might result in inaccurate results and lead you to a seemingly undervalued situation, which might actually be a value trap.

That is why it is important to trust professionals with expertise in the subject matter in valuing stocks.

Our team of research analysts analyse stocks on a regular basis and build a portfolio of 30 stocks for long-term investors throughout the year. We also provide buy price determined by our inhouse tried-and-tested valuation models.

Get 30 stocks for long term along with buy price and research reports by subscribing to Finology 30.

Conclusion

Identifying undervalued stocks requires a combination of quantitative analysis, qualitative judgment, and patience. By focusing on intrinsic value, conducting thorough research, and avoiding common mistakes, you can uncover opportunities that offer significant long-term growth potential.
Stay disciplined and avoid emotional decisions. Regularly review your portfolio to ensure it aligns with your investment goals. Remember that investing is a long-term journey; patience and persistence are key to success.
By following these steps and maintaining a focus on long-term potential, you can position yourself to capitalise on the rewards of investing in undervalued stocks.

Also, If you are looking to invest wisely with limited funds? Check out Invest in Stocks with Little Money to get started easily.