A:

Investors usually use three primary techniques for valuing companies. The first is a comparative model where a firm’s stock market metric is compared to rival companies, or similar transactions where rivals have been bought out. The second is through a discounted cash flow (DCF) analysis where the firm’s future cash flows are modeled out, then discounted back to the future to get an estimated stock value. Finally, the cost model assumes the firm is liquidated and that any leftover proceeds are sent to shareholders. Here are the ways to tell if a stock is undervalued using these techniques.

Lower Valuation than Rivals

A company could be undervalued if it is trading below similar companies. For instance, if it has a lower price to earnings or price to book value than a rival, it could be a good deal. Of course, it could have lower profit margins, have higher debt levels, or be growing slower than rivals. The ideal scenario is to find a firm that is more profitable, growing faster, and more conservatively managed that is trading at a lower multiple of earnings or cash flow than the peer group.

Intrinsic Value above Market Value

The DCF approach is the essence of stock valuation. If the firm’s future cash flows per share are discounted back to today and the value is significantly above where the stock is trading at, then the stock is likely undervalued. Estimating the cash flows can take time, and the wider the value disparity the better, which helps offset the risk that the cash flow estimates were off or don’t turn out as expected.

The Company is Worth More Dead

If a firm’s book value per share, or shareholders’ equity divided by the shares outstanding, is above the current share price, then its stock could be undervalued. This is the theoretical value that exists if all of a firm’s assets were sold and the proceeds were used to pay off its liabilities. This leftover value would go to shareholders.

The Bottom Line

There are many ways to investigate if a firm is undervalued. Simply, if the firm grows faster than the market is expecting, or its current intrinsic value is not well represented in the stock price, it is possible an undervalued company is a good bet for some investors.

At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.

RELATED FAQS
  1. What technical indicators can I use to find undervalued stock?

    Technical analysis uses statistics related to market activity, such as past prices and the volume of shares traded, to identify ... Read Full Answer >>
  2. What is the difference between fundamental and technical analysis?

    These terms refer to two different stock-picking methodologies used for researching and forecasting the future growth trends ... Read Full Answer >>
  3. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  4. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  5. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  6. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
Related Articles
  1. Investing

    Peer Comparison Uncovers Undervalued Stocks

    Learn how to put one of the top equity analysis tools to work for you.
  2. Investing

    Use Breakup Value To Find Undervalued Companies

    Find out a company's worth if it were sold in pieces - it may be more than you think.
  3. Stock Analysis

    How to Find Quality Stocks Amid the Wreckage

    Finding companies with good earnings and hitting on all cylinders in this environment, although possible, is not easy.
  4. Stock Analysis

    Analyzing Sirius XM's Return on Equity (ROE) (SIRI)

    Learn more about the Sirius XM's overall 2015 performance, return on equity performance and future predictions for the company's ROE in 2016 and beyond.
  5. Stock Analysis

    The 5 Best Stocks That Pay Monthly Dividends (PSEC, LTC)

    Get the scoop on five of the best stocks that pay regular monthly dividends, offering investors looking for regular income dividend yields of up to 16%.
  6. Stock Analysis

    The Top Rated Dividend Paying Stocks for 2016 (ABBV, BA)

    Discover five of the top-rated stocks that pay investors solid dividends that you may want to consider adding to your investment portfolio in 2016.
  7. Stock Analysis

    Will Virtusa Corporation's Stock Keep Chugging in 2016? (VRTU)

    Read a thorough review and analysis of Virtusa Corporation's stock looking to project how well the stock is likely to perform for investors in 2016.
  8. Stock Analysis

    Analyzing Porter's Five Forces on JPMorgan Chase (JPM)

    Examine the major money-center bank holding firm, JPMorgan Chase & Company, from the perspective of Porter's five forces model for industry analysis.
  9. Stock Analysis

    Analyzing Dish Network's Return on Equity (ROE) (DISH, TWC)

    Analyze Dish Network's return on equity (ROE), understand why it has vacillated so greatly in recent years and learn what factors are influencing it.
  10. Investing Basics

    The Importance of Commodity Pricing in Understanding Inflation

    Commodity prices are believed to be a leading indicator of inflation, but does it always hold?
RELATED TERMS
  1. Undervalued

    A financial security or other type of investment that is selling ...
  2. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  4. Golden Cross

    A crossover involving a security's short-term moving average ...
  5. Percentage Change

    Percentage change is a simple mathematical concept that represents ...
  6. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, ...
Hot Definitions
  1. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  2. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  3. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  4. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  5. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
Trading Center