Undervalued stocks are stocks that is selling for ‘cheap’, or stock which you believe has a true value that is higher than the selling value. The goal is to buy undervalued stocks and sell the stock when it is overvalued to make a profit.
There are several books on the market that discuss how to determine what stocks are undervalued, including “Intelligent Investor”. Graham, the author of “Intelligent Investor” believed that he could predict which stocks would be undervalued based on mathematical calculations, such as low price/earning ratio. Warren Buffet, a famous U.S. billionaire, disagreed with Graham, stating that in order to determine value of stock, a person would need to predict the future profits and future interest rates of an organization and that the business value can be summed up the cash flows over the life of the business discounted at an appropriate interest rate.
Buffet also gained much of his wealth by following a simple plan; an excellent stock at a fair price is a better value than a poor stock at a cheap price. This model requires patience, as the purchaser may have to wait several years for the excellent stock at a fair price to rise in value. Buffet and his partners also needed to consider price/cash flow ratios for success. This is a way of comparing the organization’s market value to the actual cash flow. Another way Buffet was able to troll for the most undervalued stock was to look at the price to book ratio. This measurement looks at the value the market places on the book value of the company. Price/Book = Share Price/Book Value for each Share. Like the price/earning ratio, the lower the price/book ratio, the higher the value of the stock. All of these ratios may seem complex, but there are several website on the market that can help an investor make educated decisions to make a profit. Typically, finding undervalued stock picks, then turning a profit on these stocks can take patience, but the return is worth it in the end.
