scorecardresearchStock undervaluation: What is it and what causes this?

Stock undervaluation: What is it and what causes this?

Updated: 08 Aug 2022, 07:53 AM IST

Investors often look to buy undervalued stocks i.e. stocks that are available at a price less than their intrinsic value. However it is crucial to understand why does this happen. Continue reading the article as we discuss the reasons behind the undervaluation of stocks.

We discuss the reasons behind the undervaluation of stocks.

We discuss the reasons behind the undervaluation of stocks.

When shares or other securities of a firm are exchanged at a lower market value than what their intrinsic worth indicates, this is referred to as undervaluation of stocks. The financial statements, cash flow, earnings, management of capital, and returns on assets may all be used to evaluate the intrinsic value of the stocks based on the company's fundamentals.

Investors frequently hunt for undervalued stocks to buy. The theory behind it is that opportunities for profit will arise when market prices adjust over time to reflect an asset's fair worth. Finding undervalued stocks requires more than simply locating inexpensive stocks. Instead than buying worthless stocks at a deep discount, the trick is to hunt for high-quality stocks that are trading below their true value. The significant difference is that over time, high-quality equities will increase in value.

But why are the stocks undervalued is the real mystery. It can occur often for a variety of reasons. Let us decode the reasons behind the same.

Negative publicity

The value of a company's stock always decreases when it finds itself in a circumstance that generates negative media attention. Such negative publicity, meanwhile, is only one of the numerous obstacles a company must confront and overcome. Such coverage's momentary loss of share value is not always a sign that it will completely collapse.

Market trends

Investors are urged to place transactions according to the market's trend and make decisions regarding the sale or acquisition of assets accordingly. Investors queue up to buy shares when the market's overall momentum is high, and due to the herd mentality, they join up to sell shares when it is down. As a result, the shares are undervalued.

Overall economic conditions

The market as a whole weakens when the economic indicators of a nation are unfavorable, which is perhaps the most frequent reason leading to undervaluation of shares. Due to these unfavorable circumstances, the market value of a number of shares declines. To estimate the value of shares, investors need have a fundamental knowledge and understanding of the state of the economy.

Cyclic behavior

Shares of a corporation are valued according to its profits. Due to the seasonality of a company's production and sales, they are frequently cyclical. Additionally, a cyclical pattern in the demand for its goods and services may be observed. Therefore, even if a company like this has solid fundamentals, its stock price will fall during a decline in sales before rising again when its earnings increase.

Price- earning ratio

The price to earnings ratio of a corporation shows the share price in relation to the earnings that are attributable to that share from the equity capital that the company has raised. A high P/E ratio indicates that the stock price will be higher than the earnings generated from it. On the other side, a low P/E indicates greater earnings relative to the share's purchase price.

There is no assurance that what some consider to be undervalued will also be seen in that light by others. There's no guarantee that the stock price will ever increase to what some investors consider to be a fair value, so buying inexpensive stocks is not always a good deal. The investors should do their research before investing in them.

Let’s take a look at the difference between ETFs vs. Stocks vs. Mutual Funds.
First Published: 08 Aug 2022, 07:53 AM IST