Undervalued Stocks: Common Man’s Guide For Stock Investing [2020]

[Updated: 06-Jun-2020] 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.

For profitable investing in stock market, it is important for investors to buy undervalued stocks and sell them when price nears overvaluation. This is called value investing. But unfortunately many do not know the utility of value investing.

A common man practicing value investing can be far more rewarding than day trading (in terms of risk of loss involved). Hence it will be interesting to know more about undervalued stocks.

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.)

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?

“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?

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.

Once this list is prepared, follow a “wait and watch strategy”. How to do it? Wait for the stock market to fall (correction, or crash).

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?

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.

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.

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]

QUICK TIP

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.

How?

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 06-Jun-2020: These stocks has enterprise value less than its market capitalisation.

Small Cap

1. Ketan says:

I must say your blog is excellent for layman’s understanding. Salute to your dedication for sharing knowledge in extremely easily understandable write up.

Refer Karan says:
25-03-2020 AT 11:48 AM
According to your table, all the stocks are undervalued.
NALCO
Rishabh Digha Steel
Hind. Zinc
Energy Dev. Co.
REC.
Aren’t all undervalued when CP of all of them is lower than their respective FP… ?

Mani says:
25-03-2020 AT 11:55 AM
These stocks had enterprise value less than its market capitalisation.

I don’t understand your reply. I understand that from your table Karan’s question is correct. I need to know how RDS & HZ overvalued?

2. Hazmat says:

Dear Mani Sir, In your article it says if inflation is showing a downtrend, future growth may not be as great. As per my understanding, if there is downtrend in inflation, then P/E will also be reducing for the index, low p/e hints towards undervaluation, low inflation means there will be spending from the public, so how future growth may not be great ?
Generally I use your worksheet to check fundamentals and valuation, but this question I asked for my understanding, my analysis might be wrong as I am still at the learning stage.

• MANI[sh] says:

I’ve quoted it based on the data. Please check the justification provided in the article itself.

3. Nisha says:

Thanks for sharing your valuable analysis knowledge and helping us to learn.

4. Pankaj jain says:

1st time I see such kind of simple explanation for a very complicated thing. Thanku

5. Mahajan Gumte says:

Why there isn’t pharma companies in above undervalued company list except natco pharma. Are they really overvalued?

• Mani says:

Due to their negative past performance. Future is good post COVID

6. Anitha K says:

I am new to stock investing and find your blog very easy to understand and follow with a wealth of information. Just a query though – is there a starting point for beginners like me , as in a guide to go through the articles in some order for better understanding? Right now am reading your articles in random order

• Mani says:

Thanks for a deep query.

7. Bharatbhushan Bhagwat says:

Sir,
I have started using your Stock Analysis Worksheet recently. It is very useful and user friendly.
I find one difficulty of getting fig of “Shares in Issue” from Moneycontrol site. They are publishing only fig in %. From where to get that fig.
Time being I am using BSE site for that fig. But it mentions “No of fully paid equity shares held” and ‘Total No. of shares held” (which includes No of shares underlying Depository Receipts). Which value shall I use from above?

• Mani says:

Please refer the FAQ’s in the product page. The solution is provided there. Thanks.

8. Vijay Kumar says:

Sir, am keep investing in stock market since 3 years. I have gone through many blogs but this is one of the platform where beginners can easily understand with ur common english. I like ur analysis and views on each topic brought here. Its helpful.
Can u keep a separate tab in ur blog and provide ur continuous view on trending stocks so it will help to pick a right stock at right

• Mani says:

9. Karan says:

According to your table, all the stocks are undervalued.
NALCO
Rishabh Digha Steel
Hind. Zinc
Energy Dev. Co.
REC.
Aren’t all undervalued when CP of all of them is lower than their respective FP… ?

• Mani says:

These stocks had enterprise value less than its market capitalisation.

10. DR G RAJKUMAR GOVINDASAMY says:

amazing collection sir thank you

11. Ramakant says:

Dear Mani Ashirvaad from a senior citizen, for depth study through superb calculation.

• Mani says:

Thank you sir for your blessings.

12. Ankur Anand says:

Thanks for sharing the post. The way you narrated the post is good and understanding. After reading this post I learned some new things. Keep posting. Please let me know for the upcoming posts.

13. Chris says:

Hello! I just came accross your website and I must say it is one of the BEST blogs I have come accross. The way you explain things, the way you share your knowledge and findings, the way you explain in simple lay man language, your graphs and infographics – everythings shows how much passion you have for this subject and to share this knowledge so generously with others. What I like the best about you is that you don’t give recommendation to buy A or B stock. You give us tools to analyze and make our own decison. Thank you so much for this wealth of information on analyzing stocks that I didn’t find in a single place on the web. Wishing you all the best for your future.

• Mani says:

It is the feedback like this that keep me going. Thank you.

14. JJ says:

Have you heard of the new URBT stock that is rising? With the shares that I have purchased I made some money off URBT but I would like others to look in to it as well.

15. Dheeraj says:

Such a beautiful piece of information ever I have seen in a blog.

16. R V Aravintraj says:

very useful article

• Siddharath singh says:

The insights you give here are PURE GOLD.
Outstanding.

17. Sohan says:

I like your valuable a d genuine recommendation. 2 years back in 2017 you have recommended SYNGENE INTERNATIONAL, TODAY THEY DECLARE BONUS SHARE

• Mani says:

Thanks, but I do not really recommend shares. I just share my analysis. But it’s good that it helped. Thanks a lot for giving your feedback. Readers like you keeps me going. Ciao