Key Takeaways
- Undervalued refers to an asset priced below its perceived intrinsic value, representing a potential buy opportunity for investors.
- Value investing involves purchasing undervalued stocks to profit from the difference between intrinsic and market value.
- Determining a stock’s intrinsic value requires financial analysis but remains inherently subjective and may challenge efficient market theory.
- Successful trading on undervalued stocks questions the efficient market hypothesis, suggesting some may find profit in market inefficiencies.
- See our best online brokers to find undervalued stocks.
What Is Undervalued?
Undervalued refers to an asset or security priced below its true intrinsic value, representing a potential buying opportunity for investors. Understanding undervaluation is crucial for investors who aim to purchase assets at a price lower than their actual worth, thereby optimizing investment returns. Buying stocks when they are undervalued is a key component of famed investor Warren Buffett’s value investing strategy.
Investors often rely on financial statements and key metrics such as free cash flow, return on assets, and profit margins to assess whether a stock is undervalued. We’ll explain how to identify undervalued stocks and their role in value investing.
Analyzing Undervalued Stocks in Value Investing
Value investing is not foolproof, however. There is no guarantee as to when or whether a stock that appears undervalued will appreciate. There is also no exact way to determine a stock’s intrinsic value—which is essentially an educated guessing game. When someone says that a stock is undervalued, all they are essentially saying is that they believe the stock is worth more than the current market price, but this is inherently subjective and may or may not be based on a rational argument from business fundamentals.
An undervalued stock is believed to be priced too low based on current indicators, such as those used in a valuation model. Should a particular company’s stock be valued well below the industry average, it may be considered undervalued. In these circumstances, value investors may focus on acquiring these investments as a method of pulling in reasonable returns for a lower initial cost.
Whether a stock is actually undervalued or not is open to interpretation. If a valuation model is inaccurate or applied in the wrong way, it could mean the stock is already properly valued.
Exploring Value Investing and Its Focus on Undervalued Assets
Value investing is an investment strategy that looks for undervalued stocks or securities within the marketplace with the goal of purchasing or investing them. Since the assets can be acquired at a relatively low cost, the investor hopes to improve the likelihood of a return.
Additionally, the value investing methodology avoids purchasing any items that may be considered overvalued in the marketplace for fear of an unfavorable return.
How Undervaluation Relates to Subjectivity and Market Efficiency
The idea that a stock can be persistently undervalued (or overvalued) in such a way that an investor can consistently achieve above-market returns by trading on these mispriced stocks, notably, conflicts with the idea that the stock market makes fully efficient use of all available information. If a stock were truly of greater intrinsic value than its market price, and this was readily ascertainable from its financial statements, then all market traders would have an immediate incentive to buy the stock, and in doing so bid up the price to its intrinsic value.
In other words, if markets are efficient then finding a truly undervalue stock should be near impossible (unless one has inside information not available to other market participants). This means that an investor who thinks a given stock is undervalued is inherently making a subjective judgment contrary to the rest of the market (barring insider information). It also means that the existence of successful value traders who can consistently outguess the market would be a challenge to the idea that markets are efficient.
Comparing Value Investing with Values-Based Investing
Values-based investing is the concept of buying shares in companies based on an investor’s personal values. It different from value investing that looks for underpriced stocks. In this investment strategy, the investor chooses to invest based on what they personally believe in, even if market indicators do not support the position as profitable. This can include avoiding investments in companies with products that they do not support and directing funds to those they do.
For example, should an investor be against cigarette smoking, but support alternative fuel sources, they would invest their money accordingly. This type of investing implies that the investor considers first whether the product and sector are in line with their values.