Undervalued stocks definition
Undervalued stocks are stocks traded at a lower price than what the stock is worth.
This means the company is being traded at a discount on the stock market. Indeed, when you invest in stocks, you buy a piece of a company. To quote Peter Lynch, who was, among other things, former vice chairman and director of research of Fidelity Investments:
This means the company is being traded at a discount on the stock market. Indeed, when you invest in stocks, you buy a piece of a company. To quote Peter Lynch, who was, among other things, former vice chairman and director of research of Fidelity Investments:
"Although it's easy to forget sometimes, a share is not a lottery ticket. It's part-ownership of a business."
As such, an undervalued stock is simply a share (a piece of ownership) of a company traded at a lower price than its fair price. Investing in those stocks is the "value-investing" approach of Benjamin Graham. This approach defines undervalued stocks as those "that are traded for less than their intrinsic value."
To illustrate all the above, let's imagine that company A is worth $1,000,000 and has 100,000 shares. If you buy some shares at 10$, you are buying them at their fair price.
If the shares are traded at 8$, the company is undervalued by the market. As a result, the stocks of this company would be considered undervalued.
To illustrate all the above, let's imagine that company A is worth $1,000,000 and has 100,000 shares. If you buy some shares at 10$, you are buying them at their fair price.
If the shares are traded at 8$, the company is undervalued by the market. As a result, the stocks of this company would be considered undervalued.
Do undervalued stocks exist?
Some people might argue that no one can beat the market consistently. On this premise, no stock would be undervalued as the market would price all information available. This hypothesis is called the Efficient-Market-Hypothesis (EHM).
Refuting an economic theory will not fit in an article. Like any other social science, we can always find examples or arguments to support both positions. Here, we will simply admit that humans, and investors by extension, have a cognitive bias that limits their ability to invest rationally.
This cognitive bias implies that some stocks are sought for emotional reasons rather than rational ones. If this behavior is significant, then the demand will inflate the price of those stocks. A spiraling effect can then occur as a growing price captures the attention of speculators who want to jump on the train and benefit from this growth (or bet against it by shorting the stock). As speculation drives the price, a bubble is formed.
If we admit that bubbles and irrational, excessive valuation exist, we must admit that a fair price exists. And given that any stock traded below its fair price is undervalued, undervalued stock exists.
The issue is to identify what would be the fair price.
Refuting an economic theory will not fit in an article. Like any other social science, we can always find examples or arguments to support both positions. Here, we will simply admit that humans, and investors by extension, have a cognitive bias that limits their ability to invest rationally.
This cognitive bias implies that some stocks are sought for emotional reasons rather than rational ones. If this behavior is significant, then the demand will inflate the price of those stocks. A spiraling effect can then occur as a growing price captures the attention of speculators who want to jump on the train and benefit from this growth (or bet against it by shorting the stock). As speculation drives the price, a bubble is formed.
If we admit that bubbles and irrational, excessive valuation exist, we must admit that a fair price exists. And given that any stock traded below its fair price is undervalued, undervalued stock exists.
The issue is to identify what would be the fair price.
How to find undervalued stocks?
The main idea behind this website is that valuation is relative.
In other words, a stock is undervalued today based on the market conditions and the price of the other stocks. Nothing is absolute.
Let us imagine that the S&P 500 (the 500 largest companies in the US) had an average Price-over-Earning (PE) ratio of 30. In other words, that the Shiller PE ratio is 30.
Let's assume for this example that the only metric that matters is the PE ratio. In this case, a stock with a PE ratio of 20 would be undervalued. This stock would be undervalued for as long as the other stocks have an average PE of 30. However, if there is a market crash and the average PE ratio is now 10, then a stock with a PE of 20 would become overpriced.
Therefore, our objective is to:
In other words, a stock is undervalued today based on the market conditions and the price of the other stocks. Nothing is absolute.
Let us imagine that the S&P 500 (the 500 largest companies in the US) had an average Price-over-Earning (PE) ratio of 30. In other words, that the Shiller PE ratio is 30.
Let's assume for this example that the only metric that matters is the PE ratio. In this case, a stock with a PE ratio of 20 would be undervalued. This stock would be undervalued for as long as the other stocks have an average PE of 30. However, if there is a market crash and the average PE ratio is now 10, then a stock with a PE of 20 would become overpriced.
Therefore, our objective is to:
Identify the companies performing better but priced relatively lower than their peers.
The model is conceptually simple. The tricky part is to compare the companies efficiently.
How does Undervalued.ai work?
We find the undervalued stocks by following the below automated approach:
First, we select a country and an industry because we need to compare "apples to apples." Indeed, comparing the ratios of two companies in different industries can be misleading. As an example, if we compare the Return on Assets (ROA) of a company "AAA" in an asset-intensive industry (ex: automotive, airlines, oil and gas, etc.) with the ROA of a technology company "BBB," we will often find that the ROA of BBB is higher than the one of AAA. The difference in ROA will not be because the management is always better in technology companies but rather because of the nature of the industry.
Second, we analyze the Income Statement, the Balance Sheet, and the Cash-Flow Statement. From those reports, we build a set of ratios. We display many of them on the URL of each company. Click here for more about financial ratios.
Third, we rank the companies within the same country and the same industry. Of course, not all ratios have the same importance.
Fourth, we look at several pricing signals like the PE-ratio and the evolution of its market capitalization relative to its peers.
Finally, if a company:
Then we believe this company is a candidate to be considered "undervalued."
Please note that this methodology doesn't take into account the following information, which can affect the market price of any company:
That being said, a well-managed company with solid fundamentals bought below market price is a better bet than trying to time the market.
This is not an exact science, and one should always be aware that there is a risk of loss.
As John Keynes famously said:
First, we select a country and an industry because we need to compare "apples to apples." Indeed, comparing the ratios of two companies in different industries can be misleading. As an example, if we compare the Return on Assets (ROA) of a company "AAA" in an asset-intensive industry (ex: automotive, airlines, oil and gas, etc.) with the ROA of a technology company "BBB," we will often find that the ROA of BBB is higher than the one of AAA. The difference in ROA will not be because the management is always better in technology companies but rather because of the nature of the industry.
Second, we analyze the Income Statement, the Balance Sheet, and the Cash-Flow Statement. From those reports, we build a set of ratios. We display many of them on the URL of each company. Click here for more about financial ratios.
Third, we rank the companies within the same country and the same industry. Of course, not all ratios have the same importance.
Fourth, we look at several pricing signals like the PE-ratio and the evolution of its market capitalization relative to its peers.
Finally, if a company:
- outperforms its peers,
- is priced lower than its peers,
- and has a market cap that grows slower than its peers.
Then we believe this company is a candidate to be considered "undervalued."
Please note that this methodology doesn't take into account the following information, which can affect the market price of any company:
- Any major news concerning the company, like a rebranding, a new project rollout, shutting down an activity, a major fraud, or a significant lawsuit.
- Any significant macroeconomic change like a war, a global pandemic, a fiscal policy, an embargo, or a trade agreement.
That being said, a well-managed company with solid fundamentals bought below market price is a better bet than trying to time the market.
This is not an exact science, and one should always be aware that there is a risk of loss.
As John Keynes famously said:
"The market can remain irrational longer than you can remain solvent."
Are undervalued stocks a safe investment?
Suppose one decides to invest in stocks with a "buy-and-hold" long-term strategy. In that case, undervalued stocks will likely be safer and more profitable investments than other, more expensive, stocks.
However, this is - like always - a comparative approach.
An undervalued stock is simply one investment opportunity in the stock market.
There are many other possible investments. Whether in the stock market or not. Each investment opportunity differs depending on the asset class, the country, the potential return, the taxes, or the risk exposure.
In addition, we all have different circumstances, so something safe for one person might not be safe for the other.
However, this is - like always - a comparative approach.
An undervalued stock is simply one investment opportunity in the stock market.
There are many other possible investments. Whether in the stock market or not. Each investment opportunity differs depending on the asset class, the country, the potential return, the taxes, or the risk exposure.
In addition, we all have different circumstances, so something safe for one person might not be safe for the other.
The general rule is that any investment carries a risk of loss.
The T-bills (US-Treasury bond) is used as the risk-free asset in modern portfolio theory (CAPM), as the US government should never default. But even the T-bills carry a risk, although smaller than all other investment.
As such, before investing in anything, one should always perform his research, cross information, and seek advice from trusted professionals if needed.
