What is an undervalued stock?

Simply stated, undervalued shares refer to securities that trade beneath their average market price. This can be a result of consensus estimates, low investor confidence or a mix of both. That being said, these stocks are good bets for rapid growth, thereby presenting an excellent ‘buy’ opportunity. You can calculate the company’s price-to-earnings ratio (P/E) or arrive at its growth rate in order to gauge whether stocks are truly undervalued or not.

Why are stocks rendered undervalued?

There might be one reason too many at play. These include:

  • Cyclical behaviour
  • Attribute it to the cyclical behaviour of a few businesses, it is natural that some companies go through a mesh of high and low profits, depending on the season. For instance, a multinational company invested in the business of manufacturing air conditioners is likely to experience a lean season during the winter months.

  • Herd mentality
  • Consider stock prices are falling and negative sentiments have pervaded the market. In such a scenario, chances are investors would be bearish and rush to sell their shares. What happens in the process is that instead of waiting for the market to hit the bull phase – as it invariably will – investors hastily occupy a short position and incur losses (or profits less than what they could’ve earned).

    This behaviour, besides being prevalent, permeates investor sentiments, thereby potentially amplifying the downward spiral in the market.

  • Bad rap
  • There could be bad press about a particular company’s setbacks, something that can inevitably put investors off. That being said, a company getting a bad rap isn’t a novelty, considering the fact that each organization goes through its series of ups and downs.

  • Market ‘bubble’ and eventual ‘crash’
  • Should investors decide to join the herd and follow market sentiments to the tee, panic can follow and effect a crash. One of the better examples of this is the Wall Street crash in 1929 that eventually sparked a depression.
On the contrary, a more positive herd mentality – one that is based on a fresh lease of investor confidence and reinvigorated sentiments – can contribute to what is known as a market ‘bubble’. That being said, this crest would eventually crash, once over-investment drives stock prices so high that its mandate cannot support it anymore.

How can you benefit from undervalued shares?

  • You can reap the goods of capital appreciation coupled with dividend growth
  • On top of capital appreciation over a particular period of time, investing in undervalued shares can be a good opportunity for dividend growth at a higher than usual rate. In the process, this compounds returns within a year.

  • You can reap returns even before the trend kicks in
  • An undervalued share is generally poised for growth over the long term. This implies that you could purchase the stock below its fair market price and hold it for a considerable period of time before it finally appreciates. When bulls start realizing that the stock might retain its value, it will have already appreciated by a considerable margin.
In conclusion, undervalued stocks are deemed excellent ‘buy’ opportunities, for the simple reason that they trade beneath their average market value while promising a rapid surge in prices over a relatively short period of time.

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The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.

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