Whenever we buy an article the first thing which we look at is whether the quality of the product correlates with its price. In the same way as an investor we look for those stocks which are valued according to the potential they possess. As there are many stocks in the Indian stock market which are either overvalued or undervalued. Therefore, each investor should know to identify whether the stock is undervalued or overvalued for accurate investing.
Fundamental analysis is the process of determining a company’s intrinsic qualities in order to distinguish between overvalued, fairly traded, and undervalued stocks. This article will explain the subject of stock valuation and go over methods for determining whether a stock is overvalued or undervalued.
Let’s first discuss the definition of undervaluation and overvaluation of the stock.
What is Overvaluation and Undervaluation of Stock?
Stock overvaluation occurs when the market value of a stock exceeds its actual value. A rise in emotional trading or irrational, gut-driven decisions that artificially inflate the stock’s market price, and, last but not least, a company’s financial health and fundamentals deteriorating to the point where they need to overvalue their stocks are some of the reasons that lead to stocks being overvalued.
Undervaluation of stocks occurs when shares or other securities of a company are exchanged at a lower market value than their intrinsic worth.Investors are constantly on the lookout for undervalued stocks to purchase. The theory behind it is that profit opportunities will arise as market prices adjust over time to reflect an asset’s fair value.
Methods of determining whether the stock is Undervalued or overvalued
Though there is a single method which are applicable to all type of stocks of various but still there are exceptions which results in minor modifications:
Price to Earning ratio: This is the most common parameter used by almost every investor to determine the valuation of the stock. Price to earning ratio popularly known as P.E, ratio is calculated by dividing the current share price by the earnings per share, one can determine the price to earnings ratio. This ratio demonstrates the amount of money an investor is willing to spend for every rupee of earnings.
For example if we take reliance its P.E ratio is 23 which means that an investor has to pay Rs 23 to obtain Rs 1 earning.
Formula: Market price of the share/ Earning per share
It is effective when it is compared among competitors. Higher P.E denotes Overvaluation of stock whereas Lower P.E. denoted undervaluation. P.E. ranging between 20-30 is considered good.
However, sometimes a higher P.E. ratio is also due to the company’s huge growth potential in future and increased earnings.
Price-Earning to Growth ratio: To enhance the accuracy of Price to earning ratio in determining the valuation of the company, it is adjusted with the growth of the company. It is computed by dividing the P/E ratio by the rate of increase in the company’s earnings. A corporation that has below-average earnings and a high PEG ratio may have overpriced stock, on the other hand the companies with more earning and less PEG ratio are considered as undervalued.
Formula: P.E. ratio / EPS Growth rate.
Return on Equity (ROE): Return on equity (ROE) is a ratio that measures a company’s profitability in relation to its shareholders’ equity. It is calculated by dividing the net income of a company by its equity. A lower ROE indicates that the stock is overpriced. This means that the company cannot generate a higher income than the shareholders’ investment. Whereas a higher ROE denotes that the stock is underpriced.
Dividend Yield: The dividend yield formula evaluates the relationship between a stock’s dividend and its share price. A larger percentage denotes a higher dividend payment from the corporation in relation to the stock price which is generally a sign of undervaluation. That’s why many investors prefer undervalued companies for their investment as they have higher dividend yield.
Capital Intensive stocks
To determine the valuation of the capital intensive stocks using P.E. ratio won’t be accurate to measure as they generally have higher P.E. Ratio.
For them there are certain ratios such as
EV/EBITDA ratio: A company’s Enterprise Value (EV) is measured against its Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). This is used specifically in the power, internet, and telecommunications industries, which are capital-intensive, where companies take years to break even and profit. The P/E ratio is not a good metric for them.
Where does an Investor prefer to invest?
Most investors avoid investing in overvalued stocks as the fear bubble burst always remains in such stocks. Stocks which are overvalued have already obtained more than the expected demand. That’s why the share price generally remains high.
Investors generally favor undervalued stocks over overvalued stocks as they are the stocks which are below their intrinsic value. Which denotes ensured profit as the stock prices will recover back to its intrinsic value. Apart from this, it enables investors to purchase the shares at lower cost which is known as value investing. The risk in these investments is low because undervaluation is cyclical and the firm can recoup its original value. Undervaluation with higher growth rate is the deadly combination and provides more accuracy.
Determining the valuation of the company has become the vital part of the fundamental analysis. As many professional investors look for those stocks which are either correctly valued or are undervalued along with higher growth. This can be called the pillar of fundamental analysis as it helps investors to find out the formation of bubbles in different companies. Therefore, the above ratios are capable enough to determine the valuations of the various companies.
Undervalued stocks are investors’ favorite. They usually look for companies whose share price is below their intrinsic value. Therefore, finding out the right valuation becomes very important to determine whether the company is investible or not.