What are undervalued stocks?
Undervalued stocks are those shares whose current price is trading at a discount to its intrinsic value.
A stock whose current price is Rs.80, and its estimated intrinsic value is say Rs.100, such a stock is said to be trading @20% undervaluation.
Undervaluation: The Concept
Suppose there are two 2-BHK flats in Mumbai. One is located in Kandivali and other is located in Andheri.
The distance between these two location is just 10Km.
You are an investor who is willing to buy a property in either of these two locations.
But there is only one limitation. You will buy only that property which has a rental yield of 3%+ p.a.
It means, for you, only that property is undervalued whose rental yield is above 3% per annum.
Let’s check this table for more data on the properties:
Comparing Andheri and Kandivali, Andheri is looking better valued. Why? Because its rental yield is higher.
But still Andheri is not “undervalued” for you. Why? Because its yield is below 3%.
[P.Note: For you a property located in Belapur can fetch 3%+ yield.]
So, what is the concept of undervaluation?
For an asset to become undervalued, it must be priced in such a way that it can fetch a return higher than the investor’s expectation.
Undervaluation: The Challenge of Stock Investing.
No stock can be established as undervalued (or overvalued) till we know what is it’s fair price.
How to know the fair price? By using this fair price formula:
Let’s understand this with an actual example. [Assumption: Dividend earning is the only way to make money from stocks].
Suppose you are an investor who desire to earn a return of 7% p.a. in next 12 months (from stocks).
You searched for the dividend details of few stocks. The stock data looks like this (check the below table):
- DPS: Dividend Per Share (Rs./share) – Absolute return.
- EY: Expected Yield % (Return).
- FP: Fair Price [Intrinsic Value] – (Rs.).
- CP: Current Price (Rs.)
|2||Rishabh Digha Steel||2||7%||28.57||19.1||Overvalued|
|4||Energy Dev. Co.||0.5||7%||7.14||5.4||Undervalued|
From the above table, it is easy to say which stock is undervalued and which is overvalued.
But if finding undervalued stock is so easy, why so many people loose money in stock market?
- First, Because the main return from stocks is in the form of price appreciation. Dividends contribute only a fraction of the total return.
- Secondly, not all stocks are good dividend paying stocks. Hence, their fair price cannot be simply evaluated using a formula. In fact, most best stocks in the market pay minimal or no dividends.
Had this being a dividend world, predicting future returns (fair price) of stocks would have become a lot easier.
But to extrapolate future price growth (real returns), based on current fundamentals of a company, becomes challenging.
The challenge is, how to find fair price of such stocks?
If we do not know what is a fair price, how to know if it is undervalued or not?
So, what is the solution? How to go about it?
How common men can identify undervalued stocks?
Start with following a simple principle.
“Buy ONLY fundamentally strong, undervalued stocks”.
If we can keep our investment understanding to these 6 words, we will be sorted.
- Why undervalued stocks: Because undervalued stocks can fetch higher returns in long term. Read: About high return stocks.
- Why fundamentally strong stocks: Because they represent those companies which are doing good business. Such companies tend to remain profitable no matter what. Read: About most profitable companies.
Higher returns (for investors) is a result of a combination of undervaluation and strong business fundamentals.
But everyone does not rely on undervaluation and business fundamentals while investing in stocks. Who are they?
They are stock traders? They will rather buy anything. Why?
Because they believe in profiting from momentum investing.
But this is not the investment practice which I promote in this blog.
Easier Way to Judge Undervaluation of Stocks…
Easier way is to first formulate a list of few blue chip stocks.
How this is useful?
- Bull Market: In such a market, main indices like Sensex and Nifty is only going up. When indices are rising, fundamentally strong stocks tend to become overvalued. Read: Top companies of Sensex.
- Bear Market: In such a market, the main indices falls (called correction or even crash). When indices are falling, even fundamentally strong stocks tend to get undervalued. Read: Signals of a market crash.
But it is not sufficient to see index movements alone.
To get a more meaningful idea, I prefer to look slightly deeper into the index’s PE & PB ratios. [P.Note: Sensex’s PE & PB ratio can be found by visiting bseindia’s website.]
Let’s see how Sensex’s P/E & P/B has changed in last 12 months:
It is interesting to observe index in terms of its PE, PB ratios.
I maintain a historical PE and PB database of Sensex. This gives me a general idea about the present valuation of the overall stock market.
In above table you can observe the following:
- Sensex jumped from 34,440 to 37,670 levels in 1 year (up by 9.3%).
- PE of Sensex jumped from 22.15 to 26.60 levels in 1 year (up by 20%).
- PB of Sensex remained nearly same.
- Dividend Yield of Sensex is down by 6%.
What these data tell about the market?
- PE is up by 20%, when the index is up by only 9.3%. is a strong signal of overvaluation. Read: Significance of Low PE.
- PB remaining same means the companies are increasing their net worth at the pace of the market, which is good. Read: About book value (net worth) of shares.
- Dividend yield coming down can mean two things, either overvaluation or, company’s are holding more of their profits. How to check this? When dividend yield is falling, and net worth is growing faster, it a sign that companies are holding more of their profits than usual. Read: about dividend yield formula.
As a general rule of thumb, stocks having PE more than 15 may be overvalued. Similarly, stocks having PB more than 1.5 may be overvalued.
Though it is an outdated rule, but it still gives investors a feel about the price valuations.
Judging Valuation: Example – Comparing Sensex with A Stock
Price Earning (P/E) Ratio of Index represents average valuations of stocks listed in stock exchange.
Presently (Oct’19) P/E ratio of SENSEX is 26.6.
Applying a rule of thumb, P/E above 15 hints at overvaluation, right?
In last 12 months, Sensex has risen by 3,200+ points. This is the reason why P/E of Sensex is trading at 26.6 levels today.
When Sensex is rising, it means its P/E ratio is also increasing. In such times, good stocks tend to become overvalued.
Let’s see an example (HUL). We’ll see how we can compare HUL with Sensex and derive a conclusion about price valuation.
A simple comparison of SENSEX with individual stocks can give insights about its valuation
Lets see what we can decode about HUL from these numbers:
- Price Growth: Sensex rose @9.38% in last 1 year. HUL’s price rose by @24.68% in last 1 year. This is almost 2.5 times more growth than Sensex. This hints at overvaluation of HUL. Read: Why stock price fluctuate.
- EPS Growth: Sensex EPS has declined by -8.92% in last 1 year. In the same period, HUL’s EPS rose by 9.29%. EPS growth of HUL is not at par with its price growth. Moreover, even when Sensex’s EPS growth is negative, market is rising. This again hints at overall market’s overvaluation. Read: High EPS companies.
- P/E Growth: Sensex P/E rose by a massive 20% in last 1 year. This growth is justified by surge in price and fall in EPS. But in the same period HUL’s P/E growth is only at 14%. This indicates a balanced growth for HUL. Read: Calculate absolute P/E of stocks.
So does this make HUL a good stock for investing?
No, because it does not stand up to our basic investing rule (buy only fundamentally strong, undervalued stocks).
HUL’s fundamentals may be looking strong (increasing EPS), but it is not undervalued. Why? Look at its massive P/E ratio. Moreover, its price growth (24.68%) in last 1 year is not supported by its EPS growth (9.29%) or Sensex’s price growth (9.38%).
To get a deeper understanding of HUL’s price we can use the stock analysis worksheet, but prima facie it doesn’t look too good.
This kind of understanding is possible when we compare Sensex movements with individual shares.
General Rule: When the overall market is overvalued, majority individual stocks (specially popular ones) also becomes overvalued.
How to know if the overall market is overvalued or undervalued?
PE ratio can give a broad idea about market valuation.
In years 1920, 1950, 2001 & 2008 etc, stock market across the world saw its worst crisis. During these moments of turmoil the average PE ratio of the stock market peaked and then bottomed.
These were the Sensex levels and its P/E ratios in last 20 years (during peaks and bottoms)….
Investors who bought stocks at bottom, made handsome profits. But this is only one side of the story.
There were investors who bought stocks during peaks. Like in Feb’00, Dec’07, Sep’10 etc. PE ratio of the market was at all time highs during these times.
Buying stocks when market has already peaked can be really bad.
So does it mean that now (Oct’19), when Sensex is at 37,600 levels, market is overvalued?
Just because of the fact that Sensex is at all time high, does not make it overvalued. The answer this question needs to be double checked by looking deeper in P/E levels of Sensex.
I have indicated FOUR points of interest in the above table. What inference we can make from these points?
Presently (Oct’19): The Market is overvalued?
- Past P/E: What was the PE ratio in Feb’00? 24.32. What was the PE ratio in Dec’07? 26.94. What was the PE ratio in Sep’10? 22.99. What does it show? Generally speaking, whenever the market has breached the PE23 market, it has crashed.
- Current P/E: What is the PE ratio of Sensex today (Oct’19)? It is 26.6. Looking at this historical data, possible Sensex correction looks probable any time soon.
But what Sensex patterns has to say about – what stock to buy?
If Sensex is tending towards overvalued levels, it does not necessarily mean that individual stocks are also overvalued.
But when Sensex becomes overvalued, market will crash sooner or later. When market crashes, stock price of all shares will fall.
It is this time, when prices of all shares is falling, buying stocks of fundamentally strong companies makes sense for common men.
If you can, wait for the possible stock market correction and then buy stocks.
[P.Note in the above table: After the indicated stock market crashes, the PE of Sensex fell close to our rule of thumb of 15 and then bounced back again]
Effect of Inflation of Price Valuation of Stocks
In countries like India, investors must also look into inflation. PE ratio is (and hence price valuation) effected by inflation rates. How?
High inflation rates effects the sentiment of the market. How?
- Buyers/Customers feel the pinch of soaring prices.
- Companies expenses goes up rapidly resulting in less profits.
- When customers are buying less, and companies are making less profits, EPS falls further.
- When EPS falls PE ratio increases, making stocks overvalued.
Controlled inflation is good for the economy. But erratic and stubbornly high inflation rates are worrisome.
Having said that, it must also be noted that stock market do not work well in economies having low inflation rates.
Please see the below chart to correlate the performance of Sensex with prevailing inflation in India.
- Year 2000 and 2011: This is a time span of 11 years. Inflation was rising in India. It rose from 4.84% (year 2000) to 12.11%. levels. In the same period, Sensex rose from 5000 (year 2000) to 20,00 levels. Within this period, growth in Sensex was good at the rate of 13.13% per annum.
- Year 2011 and 2019: This is a time span of 8 years. Inflation was falling in India. It fell from 12.11% to 7.39% levels. In the same period, Sensex rose from 20,00 to 37,600 levels. The growth in Sensex was decent at the rate of 8.24% per annum.
[Must Read: Subprime Mortgage: The cause of 2008 Market Crash]
Could you get the pattern?
Between the periods when inflation was soaring (2000-2011), Sensex did better. Between the periods when inflation was falling (2011-2017), Sensex still performed well but not as good as previous years.
What does it mean? I means, an inflationary economy is good for the stock market.
It does not mean that high inflation is better for the market. Why? Because high inflation is not good for the consumers (common people).
There must be a balance. This is where our RBI needs to keep a proper check & create a balance.
So what it means for stock investors?
Investors must not feel scared when inflation is rising (in a controlled way). Market may perform better in those times.
So when one has to buy stocks, keep a look at the varying inflation charts. If it is showing a downtrend, future growth may not be as great.
But a controlled inflation is a sign of a soaring index.
[P.Note: Whenever inflation rate peaks (like 12.11% in Dec’10), the stock market will either correct itself or crash. This is a good time to find undervalued stocks]
A quick comparison of companies “Enterprise Value” and its “Market Capitalisation” gives a nice first hand idea of whether a stock may be undervalued or overvalued.
This is again one of the easier ways to identify undervalued stocks in India.
Stocks whose enterprise value is less than their market capitalization can be assumed to be trading at undervalued price levels. Read more about enterprise value of stocks.
Enterprise value = Market Cap + (Debt – Cash)
Suppose there is a company which has huge cash reserves. Its cash level is so high that it can pay-off its total debt from its cash reserves only (cash > Debt). This is a rarest of rare case.
In such a case, using the above equation, the companies enterprise value will be less than its market cap.
Such companies can be assumed to be undervalued.
Undervalued Stocks in India…
- Updated as on Oct’2019: These stocks has enterprise value less than its market capitalisation.
|2||SBI Life Insurance||824.3||79,979||82,400||19.18||15.50|
|9||GIC of India||223.0||26,085||39,018||10.15||65.14|