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.

  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. How is working capital different from fixed capital?

    There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
  4. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  5. Do variable annuities guarantee returns of principal?

    Variable annuities are subject to the ups and downs of the market, so they do not guarantee returns of principal. To mitigate ... Read Full Answer >>
  6. Should I sell my shares if a company suspends its dividend?

    Since 2008, when the Federal Reserve slashed interest rates to zero and then kept them there indefinitely, dividend-paying ... 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. Retirement

    The Best Strategies to Maximize Your Roth IRA

    If a Roth IRA makes sense for you, here are ways to build the biggest nest egg possible with it.
  4. Investing

    In Search of the Rate-Proof Portfolio

    After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
  5. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  6. Chart Advisor

    ChartAdvisor for November 27 2015

    Weekly technical summary of the major U.S. indexes.
  7. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  8. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  9. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  10. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  1. Undervalued

    A financial security or other type of investment that is selling ...
  2. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, ...
  3. Confirmation

    The use of an additional indicator or indicators to substantiate ...
  4. Qualitative Analysis

    Securities analysis that uses subjective judgment based on nonquantifiable ...
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  6. Liquidity

    The degree to which an asset or security can be quickly bought ...

You May Also Like

Hot Definitions
  1. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  2. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  3. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  4. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  5. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  6. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
Trading Center