[List of Undervalued Stocks] What are undervalued stocks? They are such stocks whose current price is trading at a discount to their intrinsic value. A stock whose current price is Rs.80, and its estimated intrinsic value is Rs.100, is said to be trading at a 20% undervaluation.
Investing in stocks is always done with the theory to buy stocks at undervalued price levels. It is called value investing. How to find undervalued stocks? This is what we’ll read in this article. Generally speaking, popular stocks trade at overvalued price levels. Hence, expert investors look for value among stocks that are currently out of favor.
List of Undervalued Stocks in India
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Undervaluation: The Concept
Suppose there are two 2-BHK flats in Mumbai. One is located in Kandivali and the other is located in Andheri. The distance between these two locations is just 10Km. You are an investor who is willing to buy a property in either of these two locations. But you’ll buy only a property whose rental yield is 3% or higher. It means, for you, a property whose yield is 3% or higher is undervalued.
Let’s check the below table for some data on the property prices and their potential rental yield.
Comparing Andheri and Kandivali, Andheri is looking better valued. Why? Because its rental yield is higher. But still, Andheri is not undervalued for you as its yield is below 3%. Just for reference, a property in Belapur can fetch a 3% yield.
Takeaway: 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.
The Challenge of Stock Investing
The challenge in value investing is in the estimation of the intrinsic value (fair price) of individual stocks. Identification as undervalued or overvalued stock is not possible till we know the fair price. How to know the fair price? There is a process to calculate the intrinsic value of stocks. One Example: A simple way to estimate the fair price is by using the below formula:
Let’s understand this with an example of dividend-yielding stocks. Suppose you are an investor who desires to earn passive income from your assets. Your expected yield from the asset is 4% per annum. You’ve researched a few stocks for their dividend details. The stock data looks like this (check the below table):
From the above table, it is easy to find undervalued or overvalued stocks. But if finding undervalued stock is so easy, why do so many people invest blindly in the market? There are two reasons for it:
- First: Estimating the intrinsic value of a stock is not as easy as one might assume seeing the above example. It is a skill that develops after years of study and practice. It will not be an overstatement to say that the majority of people do not have time to learn even the stock basics. Learning intrinsic value estimation is comparatively tougher.
- Second: To be successful in stock investing, one must not only focus on price but on the fundamentals of the business as well. This makes the whole process of stock analysis ever more complex. Without fundamental analysis, long-term investing in stocks is too risky. But again, learning and practicing fundamental analysis is time taking. Hence, the majority of people give up and follow normal stock trading.
The challenge is to do a complete stock analysis.
How To Find Undervalued Stocks
Looking for undervalued stocks when the market is at its peak may become a futile exercise. I’ve personally wasted hours doing it. It is true that there are always value stocks hidden in any type of market. But finding them is easier when the market is not at its peak. With this premise, allow me to show you two steps of how to find undervalued stocks:
Step A. Analyze the Index
Before we go ahead and start analyzing individual stocks for price valuation, let’s analyze the index first. This will be done in the following three sub-steps:
Step #A1 – Index Watch
In this step, we must watch the movements of the two big indices, the Nifty50, and Sensex. While we are observing the index, we are actually waiting for the index to correct or crash. How this is useful?
- Bull Market: In such a market, main indices like Sensex and Nifty are only going up. When indices are rising, fundamentally strong stocks tend to become more overvalued.
- Bear Market: In such a market, the main indices fall (called correction or even crash). When indices are falling, even fundamentally strong stocks tend to shed their price, hence they get undervalued. Read more on the bear market.
In the pursuit to find undervalued stocks, the task becomes comparatively easier during periods of corrections or a crash. But it is not sufficient to watch index movements alone. We have to do more. Read step #A2.
Step #A2 – Look Deeper Into The Index
Look slightly deeper into the index’s PE & PB ratios. Sensex’s PE & PB ratio can be found by visiting BSE & NSE’s website. Let’s see how Sensex’s P/E & P/B have changed in the last 12 months:
It is interesting to observe the index in terms of its PE, and PB ratios. I maintain a historical PE and PB database of Sensex. This gives me a more accurate perspective on the present valuation of the overall stock market.
Following observation from the above table
- Points Movement: Sensex jumped from 55,583 to 59,670 (up by 7.66%) between Aug’21 and Aug’22. In the same period, Nifty50 jumped from 16,563 to 17,825 points (up by 7.62%). Looking at this movement, we can assume that the market is following an overvaluation trend.
- P/E Movement: Sensex PE fell from 30.27 to 23.26 (fall by -23.16%) levels between Aug’21 and Aug’22. In the same period, Nifty50 PE fell from 25.62 to 21.34 levels (fall by -16.71%). Though the indices have moved up, their PE is falling. It points toward the market becoming undervalued.
- P/B Movement: Sensex PB fell from 3.55 to 3.43 (fall by -3.38%) levels between Aug’21 and Aug’22. In the same period, Nifty50 PB fell from 4.31 to 4.18 levels (fall by -3.02%). Falling PB is again hinting towards a trend leading to undervaluation.
- The dividend Yield (DY): Sensex’s DY jumped from 0.97% to 1.19% (up by 22.68%) between Aug’21 and Aug’22. In the same period, Nifty50’s DY jumped from 1.1% to 1.34% (up by 21.82%). Increasing dividend yield is also pointing towards undervaluation.
Between Aug’21 and Aug’22, the indices have moved up by about 7.5%. But the P/E, P/B, and Dividend Yield (DY) numbers are hinting toward undervaluation.
Step #A3 – PE Trend Analysis of The Index
PE trend of the index can give an even clearer perspective about the market valuation.
In the years 2000-01 & 2008-09, 2020, etc stock market worldwide saw their worst crisis. During these moments of turmoil, the average PE ratio of the stock market peaked and then bottomed.
The Sensex levels and its P/E ratios in the last 25 years are shown in the above chart.
Studying this chart gives an idea about the Index’s behavior. We are trying to figure out a maximum level of PE at which the index corrects or crashes. Why does it correct? Because it has become overvalued. Here are three quick examples that will further clarify the point:
- 2000-01 Dot Com Crash: Sensex peaked by Dec’2000 before crashing. During those moments, Sensex was trading at 5,200 levels and its P/E ratio was 29.39. At these levels of P/E, the index crashed as the investors started booking profits. Beyond this point (PE29), the trend of undervaluation starts.
- 2008-09 Mortgage Crisis: Sensex peaked by Dec’2007 before crashing. At that time it was at 20,000 levels. The P/E ratio of the Sensex was 26.94. So this time, the market crashed even before it reached 2000-01 levels of PE29. Nevertheless, we can view even PE27 as a level indicating overvaluation.
- 2020 Covid Crisis: Sensex peaked by Mar’2020 before crashing. At that time it was at 41,000 levels. The P/E ratio of the Sensex was 28.37. So this time, the market crashed getting very close to the 2000-01 levels. This is another takeaway that a PE29 for Sensex is a level to note. Once the index will reach this level, it will either crash or at least correct itself.
- 2022 Current Levels: The P/E ratio of Sensex is at 22.83 as of today (August 2022). It is far below the danger mark of PE27 or PE29. Hence we can say that today at PE23 levels, there are more chances of finding undervalued stocks than at PE27 to PE29 levels.
Takeaway: When the index is undervalued, there are more chances of finding undervalued stocks in the market. Searching for value stocks when index is at its peak (overvalued) may be a futile strategy. How to judge if the market is undervalued or not? We can study the PE of the index (Sensex or Nifty) as shown in the above three steps. As a rule of thumb, when the index’s PE is around 29, the market is undervalued.
Step B. Analyze Individual Stocks
There are about 5000 number stocks in the market. Which stocks to analyze for undervaluation when the index is falling? Principally, we must target only the stock of fundamentally strong companies. But it requires a lot of digging into their financial statements. It is a skill that must be learned and is also time-consuming.
If one does not want to go into so much detail work, one can target to buy blue chip stocks when the index is falling. Alternatively, they can also practice index investing during corrections and a crash. But it is also true that, as this approach is easy, everyone practices it. Hence, its potential returns are smaller.
This is where a tool like ours, Stock Analysis Engine (SAEngine) becomes useful. It has a pre-coded theme that screens undervalued stocks. The screener’s algorithm works by churning the following numbers from the financial reports of companies:
- Intrinsic Value: Our ‘SAEngine’ is coded to calculate the intrinsic value of the top 850 number stocks in the Indian stock market. Any of these stocks whose current price is below their intrinsic value is tagged as undervalued. Suggested Reading: Net Present Value Calculation.
- Low PE: Our algorithm loves low PE stocks. As a general rule of thumb, stocks whose PE is 20 or lower is preferred. But there are some growth stocks whose PE is higher. For such stocks, another metric is used for the evaluation (PEG). Suggested Reading: Price to Earning Ratio – Basics.
- Low PEG: It is basically an advanced version of the PE ratio. Here the company’s EPS growth factor is also used to judge if the company is overvalued. Here, our algorithm considers EPS growth rates of periods, 3-Year, 5-Year, and 10-Year. Suggested Reading: PEG Ratio – Basics.
- Low EV/EBITDA: It is a ratio that closely resembles the PE ratio. But it renders a slightly more accurate valuation than PE. Why? Because it also considers the company’s debt and cash position to judge the company’s market valuation. Suggested Reading: EV to EBITDA multiple – Basics.
Investing in undervalued stocks has two benefits. First, it greatly reduces the risk of loss when the market becomes volatile. Second, in a long term, the chances to earn above-average returns get amplified (related reading). So, in this article, we have seen how to find undervalued stocks. But I would also like to touch base on another important factor that affects the price valuation of stocks. It is inflation.
Effect of Inflation on Price Valuation
In countries like India, we cannot avoid looking into inflation numbers. PE ratio, and hence price valuation, is affected by inflation rates. How?
High inflation rates affect the sentiment of the market. How?
- Enterprise feels the pinch of soaring prices. Hence, the companies’ expenses go up rapidly resulting in fewer profits.
- Soaring prices also deplete consumer spending potential. When customers are buying less, companies are making fewer profits. Hence, EPS falls further.
- When EPS falls, the 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 the stock market does not work well in economies having very low inflation rates.