How to find Undervalued Stocks in India

How to find undervalued stocks in India

Hello friends. Today we will be discussing a topic that a lot of our Readers have requested and should be known to all investors. Today we will be covering the topic of – How to identify undervalued stocks?

We will be discussing: What does undervaluation mean? What ratios can be used to gauge undervaluation? How to identify whether the undervaluation is justified or not? Let’s start with undervaluation.

What is undervaluation?

Any stock which is undervalued is determined by a relative basis and is measured in comparison with something. For comparison, a stock’s valuation ratio is used. Comparable valuation for a stock can be done with Other companies in the same sector and having similar characteristics Or with the industry standard Or with the historical ratios of the company. When we do the historical comparison, we should check that there shouldn’t be any material changes in operations. If the business has changed then this comparison won’t justify.

See Also : Types of Orders in Stock Market

How to check undervaluation by valuation ratios?

Now let us discuss some valuation ratios that can be used for checking for undervaluation. We will see which valuation ratios use to determine whether a company’s stock is undervalued or not.

PE ratio

The first and most commonly used ratio is the Price to Earnings Ratio or PE ratio. PE ratio is derived by dividing the share price of a stock by its earnings per share. PE ratio tells us how the market is pricing each rupee earned by the company. So more the PE ratio, the more the premium a company gets for its earning power. PE ratio values can vary wildly depending on the business in question and the potential of the business.

To explain with an example as to how to use PE ratio to know undervaluation. Then let’s take an example of the cement industry. For example, the PE of Ambuja Cement is 25 while the PE of Ultratech is 35 times. Thus, Ambuja Cement appears relatively undervalued as compared to Ultratech. Similarly, we can compare Ambuja Cement’s current PE to the rest of the industry PE. We can compare with the company’s historical PE ratio as well. From this, we can see how undervalued the company is compared to the others.

Price to Book Ratio(PB Ratio)

The second ratio is the Price to Book Ratio. This metric is mainly used to understand the valuation of businesses where deriving the value of assets is easy and reliable. This asset value determines the company’s earning potential.

For example, the earning power of financial institutions is derived from their financial assets/loan books. To know which bank is undervalued or overvalued, we need to see how the market is pricing the loan book. So, HDFC Bank has a PB of 4.18 while SBI has a PB of 1.71 SBI is undervalued as compared to HDFC Bank.

PEG Ratio

The third ratio is PEG Ratio. PEG is calculated by dividing a company’s PE ratio by its Earning growth. This is calculated as the company with more earning growth will be given more price by the market. When we divide the PE ratio with earnings growth then we get a better picture of the company’s valuation.

This metric is expected to provide a better picture of valuation than the normal PE ratio. For example, suppose Bajaj Auto’s PEG ratio is 4.8 times while TVS a PEG is 5.68 times. So, this indicates that Bajaj Auto is undervalued as compared to TVS.

We can also use other valuation ratios such as “Price to Cash-Flow” and “Price to Sales” as well to compare different companies.

Undervaluation Justification

Till now we saw how to evaluate whether the company is undervalued or not. Now we need to evaluate whether the undervaluation of the company is justified or not. This is very critical as we cannot check a company based on its numbers. So let’s get started with this part.

Reasons behind undervaluation:

1. The brand strength is less than its competitors.

2. Technology is outdated compared to others.

3. A company may be undervalued due to unique or unavoidable circumstances.

4. No competitive advantage.

5. A company is in the public sector or private sector also determines its valuation.

6. Conglogmerate discounts by company.

7. Corporate governance.

Now, let’s take up a few reasons and know them in detail:

  • To check a company’s valuation, we need to see what is the company’s business. Taking ITC, it looks undervalued among other FMCG companies. ITC PE is 19, HUL PE is 67, Marico PE is 59 and the whole NIFTY FMCG PE is 41 times. On the surface, it looks like ITC is undervalued. If we dig deeper, you can see the entire earnings of ITC comes from cigarettes. If we compare ITC with other tobacco players, the situation will change. Godfrey Philips PE ratio is 19 times, VST Industries PE ratio is 15 and as discussed, ITC PE ratio is 19 times. If we compare ITC with similar business companies then we can see that ITC is not undervalued. So it is important to check the company’s business model to see whether the undervaluation is justified or not.
  • The second can be the reasons that do not impact the company’s business and the stock price is down due to some other reasons. Like, a company’s manager is stuck in a scam, or there are litigations against them Now compare them and see whether it’s impacting the companies core business. If NO, and the situation is short-term then you can take advantage of the situation and invest in that company. This is because the market will forget the scam and litigations and in the long run, the stock price will reflect the true picture of the company. So do check whether the undervaluation of the company is due to its core business values or not.
  • The third can be that the whole sector is facing a bad time and is looking undervalued than its historical valuation. In this case, check that the situation is temporary or permanent. How much the company & the industry’s fundamentals are impacted due to this situation. Also that the effect is for a short time or long period. If its short term and the company and the industry will recover eventually then you can take advantage and invest in it. For example, the travel industry was hit very hard by the COVID-19 pandemic, and the prices of all players in the industry dropped. But as everything is normalizing & we all started traveling, then the industry players have all seen a rise in prices. This is because Covid brought a temporary disturbance in the operations. The core fundamentals of the companies and the industry remain intact.
  • The fourth scenario can be that the company’s fundamentals may have changed and the change is for the better. This change is yet to be reflected in the company’s earnings and hasn’t been priced by the market. It provides an opportunity for investors to invest in the currently undervalued stock. Eventually, it will increase the company’s earnings then you can buy the stocks. For example, Tata Motors has been shifting its focus towards electric vehicles. Thus it was reflected in the rise in its share price in the past year even so Tata Motors’ stock price increased a lot. For the information that the fundamentals are changing or not, you need to research by reading news, annual reports, con calls. From this, you can know whether the company’s business strategy is changing or not, and then you can take advantage.
  • The last scenario due to which a company can be undervalued is because of market crash or corrections. The reason behind the change in the company’s price is due to market movements or external sources. This is not impacting the company’s core business & fundamentals. So when everyone is panicking in the stock market then you should act smartly and invest when they are undervalued. the stocks will be undervalued compared to their historical valuation. If you think that the company’s business, fundamentals, revenue, profit margin are intact then you can take a position in that company.

With that, we come to the end of this topic. I hope you understood how to determine the valuation of the company based on the ratios. And also how to investigate whether the undervaluation is justified or not.

Disclaimer- Any stock which has been mentioned is for educational purposes and is not a buy or sell recommendation.

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