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.
Investors seeking new ideas may want to look to technical analysis to see whether the market has undervalued a particular ...
These terms refer to two different stock-picking methodologies used for researching and forecasting the future growth trends ...
Find out more about the rising and falling wedge formations and how to implement a forex strategy when you spot these patterns ...
Learn how passive investing can make a person good money in the drugs sector, but shrewd active investing can make a person ...
A financial security or other type of investment that is selling ...
A style of investing for the relatively short term based on anticipated ...
The absolute level of a fund's investments.
Indicators are statistics used to measure current conditions ...
A technical indicator that combines aspects of candlestick analysis ...
Smart beta defines a set of investment strategies that emphasize ...