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. How do I use discounted cash flow (DCF) to value stock?

    Understand the meaning and significance of discounted cash flow, and learn how market analysts commonly use this stock evaluation ... Read Answer >>
  2. How do I calculate free, discounted and operational cash flow in Excel?

    Take a quick look at how you can calculate a company's operating cash flow, free cash flow and discounted cash flows using ... Read Answer >>
  3. What is the difference between a company's book value per share and its intrinsic ...

    Book value and intrinsic value are two ways to measure the value of a company.In simple terms, book value is based on the ... Read Answer >>
Related Articles
  1. Investing

    Should You Use DCF for Valuation?

    We explain the two primary valuation techniques—DCF and Comparables—used to predict future stock prices.
  2. Investing

    How to Choose the Best Stock Valuation Method

    Don't be overwhelmed by the many valuation techniques out there - knowing a few characteristics about a company will help you pick the best one.
  3. Investing

    Top 3 Pitfalls Of Discounted Cash Flow Analysis

    The DCF method can be difficult to apply to real-life valuations. Find out where it comes up short.
  4. Investing

    Value Investing: Why Investors Care About Free Cash Flow Over EBITDA

    Examine value investing philosophy and methodology to see why free cash flow is more important than EBITDA in pure intrinsic value calculation.
  5. Financial Advisor

    Value Investing Strategies in a Volatile Market

    Volatile markets are a scary time for uneducated investors, but value investors use volatile periods as an opportunity to buy stocks at a discount.
  6. Investing

    Taking Stock Of Discounted Cash Flow

    Learn how and why investors are using cash flow-based analysis to make judgments about company performance.
  7. Investing

    Equity Valuation: The Comparables Approach

    The main purpose of equity valuation is to estimate a value for a firm or security. There are three primary equity valuation models: the discounted cash flow (DCF), cost and comparable approaches. ...
  8. Personal Finance

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  9. Investing

    How to Invest Your Excess Cash in Undervalued Securities

    Learn how even small investors can shoot for substantial capital gains by starting to invest their excess cash in undervalued securities.
  10. Investing

    Analyzing The Price-To-Cash-Flow Ratio

    Find out how this ratio can help you evaluate companies and make investment decisions.
RELATED TERMS
  1. Absolute Value

    Absolute value is a business valuation method that uses discounted ...
  2. Discounted Cash Flow (DCF)

    Discounted cash flow (DCF) is a valuation method used to estimate ...
  3. Valuation

    The process of determining the current worth of an asset or company. ...
  4. Terminal Value - TV

    The value of a bond at maturity, or of an asset at a specified, ...
  5. Large-Value Stock

    A type of large-cap stock investment where the intrinsic value ...
  6. Comparable Company Analysis - CCA

    A process used to evaluate the value of a company using the metrics ...
Hot Definitions
  1. Stagflation

    A condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, ...
  2. Notional Value

    The total value of a leveraged position's assets. This term is commonly used in the options, futures and currency markets ...
  3. Interest Expense

    The cost incurred by an entity for borrowed funds. Interest expense is a non-operating expense shown on the income statement. ...
  4. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  5. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning an amount to a fraction, according to its share of the ...
  6. Private Placement

    The sale of securities to a relatively small number of select investors as a way of raising capital.
Trading Center