Undervalued is a financial term that is used to refer to a stock, security, or other type of investment that sells in the market for a price that is presumed to be priced at less than its intrinsic value. An undervalued security is evaluated by taking a closer look at the company’s financial statements.
By way of analysis of a company’s financials, including cash flow, return on assets, capital management, and profit generation, you are able to more accurately determine the value of a company’s stock price. The intrinsic value of a company’s stock is equivalent to the free cash flows that are expected to be made by the company.
For example, if company G is selling shares at a market price of $100, but the intrinsic value of the stock is estimated to be $200, company G’s shares are valued lower than the potential that exists. This is due to the volatile conditions in the market.
The process of investing in stocks that are undervalued is known by the term “value investing.” It was first used and brought to light by Benjamin Graham and has since been ushered into today’s market by his protege, none other than Warren Buffet.
Advantages of Undervalued Stock
Some of the key advantages of undervalued shares include:
- Undervalued stock prices will return to their intrinsic value by their very nature, and as such, profits are guaranteed
- Undervalued stocks represent the opportunity for shares to be purchased at lower prices from companies that are well-established or carry good future potential
- These types of stock offer investors low risk. This is thanks to the cyclical nature of undervaluation, as well as the fact that the potential is present for the security to attain its intrinsic value
Investing in undervalued stocks is an investment strategy that allows assets to be acquired quickly at a relatively low cost, with a high potential for a good return on the investment.
Disadvantages of Undervalued Stock
Some of the disadvantages of undervalued stock include:
- Not every investor can decide to invest in these types of stocks
- It is a time-consuming endeavor
- Investors do run the potential risk of a company having a flawed analysis
Initially, investors are advised to put their money in stocks that carry less risk, at least in the early days of investing.
Who Should Invest in Undervalued Stocks?
Undervalued stocks have a great potential to yield very substantial returns. This is only possible if an investor can properly analyze the different variables that are related to the stock. Analyzing a company’s future earnings potential is a rather technical matter that does require significant technical knowledge.
Any investor who has the necessary knowledge and expertise with regard to the stock market and its complex dynamics is urged to get involved with undervalued stocks. It is not advisable for novice investors to chase the potential for these higher returns, as the lack of expertise in this regard could end up costing them dearly.