Undervalued stocks are called those stocks that are believed to have higher target price than their stock price on the exchange. The higher is the difference the more stock is undervalued. If stock price in the market is higher than target price of the same stock then such stock is overvalued stock.
In process of selecting undervalued stocks everything depends on stock valuation. Mainly two methods are used for target price determination: relative valuation and DCF valuation, or sometimes both of these methods are used to verify each other and to make the valuation look more serious. Despite the method used for valuation, process of getting target price is always very biased and different analysts usually are getting different target prices for the same stock, so if you will find one investment report that says about strongly undervalued stocks, don’t hurry to buy them. Such valuation may be inaccurate or influenced by someone’s interests and cannot be trusted blindly.
But it doesn’t mean that investors should not look for undervalued stocks. Such stocks are also called as cheap stocks and usually have more potential to rise than overvalued stocks. But it is not so easy to find good undervalued stocks, especially when stock markets are calm and in rise. It is much easier to find undervalued stocks during bear market when investors are affected by fear.
Real undervalued stocks should have low valuation multiples (as P/E ratio, EV/EBITDA ratio, EV/S ratio etc.) and potential to rise in sales and earnings in the future, and risk of such company should be in normal levels. Naturally, such stocks should look undervalued using DCF valuation.
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