Undervalued Stock Definition
What Is an Undervalued Stock?
An undervalued stock is when the price of a stock or bond has fallen to an amount that may be better valued than what the stock market gives it credit for. These stocks are typically bought when investors believe they can sell them in the future for more than their purchase price, which is why they are called “undervalued.”
Investing in undervalued stocks is one of the most efficient ways to make money. This is because you are buying something that others either want or need, but you are getting it at a discount. There are four possible outcomes when investing in undervalued stocks:
- You can hold on to your investment until the market corrects itself and prices go up,
- you can take advantage of the discounted price and sell your stocks to another investor while they are still undervalued,
- you buy more while the prices are low and wait for them to go up in value before you sell altogether, or
- lastly, if the stock never increases in value past your purchase price then at least you have made money by selling your stock for more than you bought it.
How Do You Know if a Stock Is Undervalued?
Investors can determine whether or not an undervalued stock is just that by comparing the current price of the company with its average earnings per share over time.
The ratio of these two numbers tells you how undervalued (or overvalued) the stock is present. For example, if a company has an average P/E ratio of 12, and the current P/E is 8, it would be undervalued. The lower the ratio, the better value for your money.
Why Are Stocks Undervalued?
There are many reasons why stocks can fall into the undervalued category. A few of these reasons include:
- A new management team,
- new products or services that are having a positive impact on the company’s bottom line,
- a stock split, and
- an increase in demand for related goods.
Unfortunately, there are also several reasons why stocks fall into the overvalued category, including:
- a new management team that has mismanaged funds,
- new products or services that are not showing positive results,
- a decrease in demand for related goods.
While investors are often tempted to jump on any opportunity to buy stocks that appear undervalued, there are several reasons why this could lead them to losses in their investment. One reason is that the stock may not be undervalued at all but instead might just have had a temporary drop in price, which could lead to future losses.
Additionally, if an investor pays too much attention to buying stocks that appear undervalued, they run the risk of ignoring other potentially more profitable opportunities for investing.
Examples of Stocks That Are Currently Undervalued
Here are a few examples of stocks that may be considered undervalued:
- General Motors Company (GM)
- Lockheed Martin Corp. (LMT)
- Dow Chemical Co. (DOW)
These three companies have all been highly successful in the past, selling shares for more than $50. However, each of these companies has recently seen share prices drop below this mark.
Advantages and Disadvantages to Investing in an Undervalued Stock
Investors benefit if they buy undervalued stocks because it is possible that the price could rise again in the future, allowing them to sell for more than they paid.
However, there are also disadvantages to buying undervalued stocks because it is possible that the price could drop even further in the future. Therefore, investors must consider whether or not the benefits outweigh the disadvantages before buying an undervalued stock.
The Bottom Line
Investing in undervalued stocks can be a profitable activity, but it can also lead to greater losses. It is up to the investor to determine whether the benefits of investing in an undervalued stock outweigh the risks before taking action.
Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.