What Is an Undervalued Stock?

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DEFINITION
An undervalued stock is one that appears to be trading below what some investors might consider to be a fair price for it.

An undervalued stock is one that appears to be trading below what some investors might consider to be a fair price for it. Undervalued stocks are often looked at as part of a value investing strategy, though it’s possible for some investors to consider certain growth stocks to be undervalued at times. Let’s take a closer look at what undervalued stock means.

Definition and Examples of Undervalued Stock

An undervalued stock seems to be trading lower than what might be considered its fair value. Undervalued stocks are often part of the value investing strategy. While not everyone necessarily agrees on what a stock’s price should be, sometimes investors see misalignments between current prices and what the financial fundamentals of a company indicate. 

For example, a company might have a very low price-to-earnings (P/E) ratio, perhaps lower than similar competitors. In that case, investors might think that the undervalued stock’s P/E ratio will go up, which could mean the stock price should go up too if earnings stay the same or improve.

Investing in undervalued stock could essentially be considered a way to try to get a good deal. 

Still, there’s no guarantee that what some people think is undervalued will be perceived that way by others. The stock price might not ever rise to what some investors think is a fair value, so it’s not as if investing in undervalued stocks is an automatic bargain.

How Undervalued Stock Works

Undervalued stock comes about when investors think that a company’s share price is lower than it should be. One reason why that might occur is if a company got caught up in a broader market selloff

Perhaps bad news within the banking industry causes investors to largely sell the stocks of banking companies. Yet maybe that news only applies to certain banks, but the stock of other financial institutions less affected by the news still got sold aggressively anyway, driving their share prices down. In that case, other investors might come to see some of those unaffected stocks as undervalued.

Another reason why a stock might be considered undervalued is that investor demand has shifted to other areas, such as if a certain sector becomes popular, driving up prices. Meanwhile, the lack of demand for stock in another sector could put a damper on share-price growth, even if the underlying financials of these companies remain strong.

In many cases, what investors consider to be undervalued stocks are mature companies, so there may not be as much excitement and belief in their long-term growth prospects.

A manufacturing company that has been around for decades and continues to earn profit at a steady pace might be considered reliable. Yet that’s not necessarily going to stoke investor fire as much as a startup that has huge revenue potential, which might cause investors to buy in at a much higher P/E. Meanwhile, the stock of the manufacturing company might become undervalued if hardly anyone’s paying much attention to it, even if within the company some developments occur that arguably increase its value. 

What Undervalued Stock Means for Individuals

Understanding what undervalued stocks are can potentially help individuals make better investment decisions. 

Keep in mind that undervalued versus overvalued stocks are somewhat in the eye of the beholder, but some individuals might like the approach of looking for stocks that are trading below what seems like a fair price.

Individuals might decide to look for particular stocks that seem to be undervalued, which might be based on their own analysis, the advice of a financial advisor, news articles, etc. Or they might invest in funds that look for undervalued stocks as part of the fund’s strategy.

Other investors, however, might prefer different investment strategies. Even if you agree that a stock is undervalued, that doesn’t necessarily mean it’s the best investment for your circumstances. 

Perhaps you think that a stock is undervalued by 5%, and after it gets back to what you think is a fair price, you don’t think the company has much potential to grow. In contrast, maybe you think the stock price of a new tech company, for example, will increase by 100% over the next couple of years due to investor demand.

So maybe you’d rather put your money into the growth company even if, fundamentally, you don’t think that’s what the fair share price should be. Overall, in many investment decisions, numerous factors might be at play, such as your risk tolerance, investment horizon, and investment beliefs. 

Key Takeaways

  • Undervalued stock is considered to be underpriced by some investors.
  • Undervalued stock tends to be used in conjunction with value investing strategies, but it’s possible for some growth stocks to also be considered undervalued at times.
  • There isn’t necessarily one inherently fair valuation, so some investors might consider certain stocks to be undervalued, while others don’t see it that way. 

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Article Sources

  1. E-Trade. “Growth vs. Value Investing.”