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An undervalued stock is defined as a
stock Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the Share (finance), shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporatio ...
that is selling at a price significantly below what is assumed to be its intrinsic value. For example, if a stock is selling for $50, but it is worth $100 based on predictable future cash flows, then it is an undervalued stock. The undervalued stock has the intrinsic value below the investment's true intrinsic value. Numerous popular books discuss undervalued stocks. Examples are ''
The Intelligent Investor ''The Intelligent Investor'' by Benjamin Graham, first published in 1949, is a widely acclaimed book on value investing. The book provides strategies on how to successfully use value investing in the stock market. Historically, the book has been ...
'' by
Benjamin Graham Benjamin Graham (; Given name, né Grossbaum; May 9, 1894 – September 21, 1976) was a British-born American financial analyst, economist, accountant, investor and professor. He is widely known as the "father of value investing", and wrote two ...
, also known as "The Dean of Wall Street," and '' The Warren Buffett Way'' by Robert Hagstrom. ''The Intelligent Investor'' puts forth Graham's principles that are based on mathematical calculations such as the price/earning ratio. He was less concerned with the qualitative aspects of a business such as the nature of a business, its growth potential and its management. For example, Amazon, Facebook, Netflix and Tesla in 2016, although they had a promising future, would not have appealed to Graham, since their price-earnings ratios were too high. Graham's ideas had a significant influence on the young
Warren Buffett Warren Edward Buffett ( ; born August 30, 1930) is an American investor and philanthropist who currently serves as the chairman and CEO of the conglomerate holding company Berkshire Hathaway. As a result of his investment success, Buffett is ...
, who later became a famous US billionaire.


Determining factors

Morningstar uses five factors to determine when something is a value stock, namely: * price/prospective earnings (a predictive version of price/earnings ratio sometimes called Forward P/E.) * price/book * price/sales * price/cash flow *
dividend yield The dividend yield or dividend–price ratio of a share is the dividend per share divided by the price per share. It is also a company's total annual dividend payments divided by its market capitalization, assuming the number of shares is constan ...
Warren Buffett Warren Edward Buffett ( ; born August 30, 1930) is an American investor and philanthropist who currently serves as the chairman and CEO of the conglomerate holding company Berkshire Hathaway. As a result of his investment success, Buffett is ...
, also known as "The Oracle of Omaha," stated that the value of a business is the sum of the cash flows over the life of the business discounted at an appropriate interest rate.Warren Buffett's 1989 letter to Berkshire Hathaway shareholders
/ref> This is in reference to the ideas of
John Burr Williams John Burr Williams (November 27, 1900 – September 15, 1989) was an American economist, recognized as an important figure in the field of fundamental analysis, and for his analysis of stock prices as reflecting their " intrinsic value". He is ...
. Therefore, one would not be able to predict whether a stock is undervalued without predicting the future profits of a company and future interest rates. Buffett stated that he is interested in predictable businesses and he uses the interest rate on the 10-year treasury bond in his calculations. Therefore, an investor has to be fairly certain that a company will be profitable in the future in order to consider it to be undervalued. For example, if a risky stock has a
PE ratio Pe may refer to: Language, and letters * Pe language * Pe (Cyrillic), a letter (П) in the Cyrillic alphabet * Pe (Semitic), a letter (פ ,ف, etc.) in several Semitic alphabets ** Pe (Persian), a letter (پ) in the Arabic alphabet * Pe (Armeni ...
of 5 and the company becomes bankrupt, this would not be an undervalued stock. Some qualities of companies with undervalued stocks are: # The company's earning history is stable. # The company does not specialize in high-technology that can become obsolete overnight. # The company is not in the middle of some financial scandal. # The company's low PE ratio is not due to profits realized from capital gains. # The company's low PE ratio is not due to a major decline in profitability. # The company's PE ratio is below its average PE ratio for the last 10 years. # The company is selling at a price below its tangible asset value. # The company's trailing 3-years earnings has risen over the past 10 years. # The company's credit rating is AAA, AA, or A, or even better, there is no rating because there is no debt at all. # The company did not have a loss during the last recession. # The company's
PEG ratio The 'PEG ratio' ( price/earnings to growth ratio) is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth. In general, the P/E ratio is ...
is low. A Price/Earnings/Growth rate below 1 means the PE ratio is less than the growth rate. An excellent stock at a fair price is more likely to be undervalued than is a poor stock at a low price, according to
Charles Munger Charles Thomas Munger (January 1, 1924November 28, 2023) was an American businessman, investor, attorney and philanthropist. He was vice chairman of Berkshire Hathaway, the conglomerate controlled by Warren Buffett, from 1978 until his death in ...
, the Harvard-educated partner of Buffett. An excellent stock continues to rise in value over the long term, while a poor stock declines in value. An undervalued stock will usually have a low PE ratio. For example, a PE ratio of 10 is much better than a PE ratio of 20. Some high-flying Internet stocks had PE ratios of 30, 40, 50, 100, 200 or more in year 2000, prior to the bursting of the Internet stock bubble. Investors of these Internet stocks did not purchase undervalued stocks, as they later learned.


See also

*
Stock valuation Stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement � ...
* Value investing *
Penny stock Penny stocks are common shares of small public companies that trade for less than five dollars per share. The U.S. Securities and Exchange Commission (SEC) uses the term "penny stock" to refer to a security, a financial instrument which repr ...
*
Multibagger stock A multibagger stock is an equity stock which gives a return of more than 100%. The term was coined by Peter Lynch in his 1988 book ''One Up on Wall Street'' and comes from baseball where "bags" or "bases" that a runner reaches are the measure of ...


References

{{reflist Valuation (finance) Stock market Investment Business terms Mathematical finance Finance theories