Everyone loves a good deal. Whether you’re buying your weekly groceries or haggling over the price of a new car, there’s nothing like getting a bargain. Though you may not think of it the same way, investing in the stock market is no different.
While people are typically excited to see their favorite items on sale at the grocery store, they can often be less enthusiastic when they see stock prices fall. But the stock market’s swings create plenty of profitable bargains for those willing to look closely.
Here are four ways to tell if a stock is undervalued.
What does it mean for a stock to be undervalued?
Before you start bargain hunting, you’ll need to understand what it means for a stock to be undervalued in the first place. Stocks represent partial ownership stakes in real businesses that (hopefully) generate earnings and cash flow for their shareholders. A company’s intrinsic value, or what the business is worth, is based on the amount of cash flow the company will generate for shareholders over its life, discounted back to the present at an appropriate interest rate.
For a stock to be undervalued, it should be trading below a conservative calculation of its intrinsic value. Oftentimes, market commentators segment the investment universe into two categories: growth and value. But companies that are growing can still be undervalued and companies that appear to be undervalued can actually be in decline.
The following tips and clues can help determine whether a stock is undervalued.
1. Low valuation ratios
One of the quickest ways to gauge whether a stock is undervalued is to compare its valuation ratios to the rest of its industry or the overall market. If the ratios are below that of the industry average or a broad market index such as the S&P 500, you may have a bargain on your hands.
It should be noted that no financial ratio is perfect and investors should always seek to understand the “why” behind a disconnect between the way one company is being valued compared to others.
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