In this post, you will learn the meaning of undervalued stocks with simple examples. You will find two broad types of companies and definition of undervalued stocks for each. Also, you will two formulas that are over 50 years old – to help you find an undervalued stock.
Below is a table of contents for to help you navigate through this post.
Table of Contents
- Undervalued Stocks Meaning in a Nutshell
- What Exactly is Intrinsic Value
- How to Find Undervalued Stocks Among Large Companies That Pay Dividends
- How to Find Undervalued Stocks Among Growth Companies That Don’t Pay Dividends
- Summary (Recap): Undervalued Stocks Meaning in 2 Different Cases
1 Undervalued Stocks Meaning in a Nutshell
By definition, an undervalued stock is one whose current price is lesser than its intrinsic value.
2 What Exactly is Intrinsic Value
The intrinsic value of a stock is its true price without considering market sentiments. Every asset or product has a true value. But market price may not reflect the true value.
Is finding an undervalued stock is as simple as calculating the intrinsic value? Not really because no one can estimate the intrinsic value with hundred percent accuracy. If there was an easy way then everyone will be as successful as Warren Buffet. Finding the intrinsic value of a stock is both art and science. There are 50-year-old mathematical formulas to assist you. But there is a catch…
The formulas have parameters that you should estimate using both data and common sense. Hence, without applying your knowledge, you will not be able to use the formulas effectively.
Before learning the formulas, have a look at the two types of companies which we are talking about.
- Large or Blue-Chip Companies That Pay Dividends.
- Growth or New Companies That Do Not Pay Dividends.
Undervalued stocks are same in principle but have slightly different meanings for these two types of companies.
3 How to Find Undervalued Stocks Among Large Companies That Pay Dividends
Many large companies operating for several decades pay dividends to shareholders. For stable companies with steady dividends, you can calculate the intrinsic value quite easily. Comparing this value to the market price, you can say if the stock is undervalued or not. Now let us see a very important formula.
Dividend Discount Model (DDM) Formula
Let us assume a company called “Tasty Candy“. Assume that the company is paying dividends for shareholders. To estimate the intrinsic value, use the below formula. (This formula is a contribution in 1956 by Myron J. Gordon, a well-known American economist.)
Intrinsic Value = D1 / (r – g)
- D1 denotes the dividend at the end of the current year.
- r is the cost of equity.
- g is the annual growth rate of dividends.
Are the parameters “r” and “g” new to you? Let us discuss them one by one. If you already know them, you can skip the next few paragraphs.
Cost of Equity (r)
Cost of equity is a confusing term even for experienced shareholders. There is a simple way to understand this. Just remember this:
Cost of equity denotes the return percent you expect on a particular share depending upon its risk. Higher the risk, higher the cost of equity.
There are two ways to know or estimate the cost of equity.
- The easy way is to speak to your financial advisor or stockbroker.
- The hard way is to use a Nobel-Prize winning formula (derived from Capital Asset Pricing Model or CAPM).
Recommendation from Netcials is this:
Learn to use the CAPM formula by yourself. The reason follows. You have to make important assumptions in this formula. You will good results by making these assumptions by yourself – because you care about your money more than your advisors. Also, learning such important formulas will help you in the long run. You are not for the short-game.
CAPM Formula To Find Cost Of Equity (r)
Cost of equity = r = rf + β x (rm – rf)
- rf is the risk-free rate,
- β (beta coefficient) is a measure of volatility and
- rm is the market return rate.
Now you will see simple explanations for all the three parameters rf, β and rm.
Risk-Free Rate (rf)
You already know why many people prefer shares over bonds and deposits. The reason is expectation of higher returns. A general perception is share investments are riskier than bonds and deposits.
As a reward for the risk taken, every shareholder will expect higher returns from the shares. Now comes the explanation for rf…
A risk-free rate (rf) denotes the interest rate on safe investments. Typically, financial advisors use 10 or 20 years rate of treasury bonds as rf. For example, in your country, if the safest bonds have yielded 5% in the last 10 years, your rf will be 5%.
Note: Ben Graham, the “Father of Value Investing” used 4.4% as rf in one of his formulas. His value reflected long term AAA government bond rate.
Beta Coefficient (β)
To understand beta you should learn about benchmark index and outliers. A benchmark index like S&P 500 (if you are in the US) reflects the overall price movement of all stocks (under the index). (For your information, S&P 500 is a composite index of 500 large US companies.)
An individual stock may not follow the same path as that of S&P 500. High growth stocks will deviate from the index in the upward direction while low performing stocks will deviate in the downward direction. These highly deviating stocks are called outliers. Between the positive and negative outliers, there will be hundreds of stocks. Now comes the definition for beta…
Beta is a measure of how closely a stock follows the benchmark index. (For those with a mathematical background, beta is kind of a correlation coefficient of an individual stock with the benchmark index.) Few important values of beta and their meanings are as follows:
- A stock with beta = 1 follows the benchmark index.
- A stock with beta greater than 1 is more volatile than the benchmark index.
- Any stock with beta lesser than 1 is more stable than the benchmark index. These are very stable stocks (usually utility company stocks).
A good thing about beta is that you don’t have to calculate it manually. (Though it can be easily done using historical price data and excel.) Financial websites will give you the value of beta.
Now, let us move on to the next parameter in the calculation of the cost of equity.
Market Return Rate (rm)
The third parameter in the CAPM formula is market return rate (rm). The market we are talking about is the stock market. Financial advisors usually use 10 or 20 years return from a benchmark index as rm.
Note: While calculating rm, the duration should be the same as for rf (risk-free rate.). If you are using last 10-year return rate from AAA bonds as rf, then you have to use the last 10-year S&P 500 return rate as rm.
Now, you know the meanings for rf, rm and β in CAPM formula.
Now let us get back calculating Intrinsic Value for our example company, “Tasty Candy”. Let “Tasty Candy” be a part of S&P 500. Let the values of rf, rm and β be 4%, 10% and 1.2 respectively.
Note: While 1.2 beta is unique for “Tasty Candy”, the values of 4% and 10% for rf and rm respectively will apply for all companies under S&P Index.
If you apply the values in the formula, the cost of equity for Tasty Candy will be:
r = 4% + 1.2 x (10%-4%) = 11.2%
Now let us get back to our original Gordon formula,
Intrinsic Value = D1 / r – g
We just found r = 11.2%. Let’s move on to the next denominator, g.
“g” refers to the annual growth rate of the dividend. Now we are making an assumption that the dividend grows at a constant rate for ever. Let g be 5% in our case.
For example, if “Tasty Candy” gave out 100$ dividend last year, this year dividend will be 100 + 5% of 100 = 105. Next year, the dividend will be 105 + 5% of 105 = 5.25 and so on,
In Gordon formula, value D1 denotes the dividend at the end of current year. Therefore, D1 will be 105 based on our assumption.
So the intrinsic value = 105/11.2% – 5% = $1693.55
Now, if the market price (per share) of Tasty Candy is lesser than the intrinsic value $1693.55 then you have just spotted an Undervalued Share!
Note: Not all companies pay dividends. Hence, Gordon formula cannot be applied to all companies. For other companies, there is another formula that comes handy. This formula is called Discounted Cash Flow formula. Let us discuss what an undervalued share means in terms of discounted cash flows.
4 How to Find Undervalued Stocks Among Growth Companies That Don’t Pay Dividends
Before going further, you should know what is cash flow (CF) and what is discounted cash flow (DCF). If you are not new to share markets and have a good idea of cash flows, you can skip next few paragraphs.
Cash flow is the “real” net income of a company in a year. What we mean by “real? You have to calculate only that money actually being received by the company. For example, a company may sell products on credit and receive payments in the following year. Such income is accounted in the balance sheet under “net income”. However, a cash flow statement will not consider that amount.
Let us get back to our imaginary company, “Tasty Candy”. Now we are assuming Tasty Candy is not paying dividends at all.
Let “Tasty Candy” sells to two customers “John Cycles” and “Jude Helmets”. “John Cycles” pays 1000$ immediately. But “Jude Helmets” agrees to pay 1000$ the next year. In this case, net income for “Tasty Candy” will be 2000$ while cash flow is just 1000$.
There is another important thing to note regarding cash flow. While calculating cash flow you should never consider one-time expenses like buying a building or one-time income like selling an old building. The reason is this: If cash flow includes one time expenses/income, it will not reflect the year-on-year projected cash flows.
Now comes the well-known formula for valuation using discounted cash flow model.
Intrinsic Value = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 + CF4/(1+r)4 + CF5/(1+r)5 + …
In the above formula, CFs represent the cash flows in a particular year. For example, CF3 denotes the projected cash flow in the third year from now.
The “r” you see in the denominators is called discount rate. To understand discount rate, you have to understand the time value of money.
What is Time Value of Money
Below example will help you understand the time value of money.
Assume you earn 10000$ this year. Let a toothpaste cost 5$ today. Every year from now the prices rise (and hence inflation rises). Let the price of the toothpaste rise by 4% every year from now. So in 5 years, by the price will rise (compound) to 5 x (1 + 4/100)5 = $6.08
Note: Don’t worry if you don’t understand the above formula. This formula is not important now. All you have to understand is, the prices rise year on year.
Now, let us come to your compensation part. You earn 10,000$ this year. Since prices are going up 4% every year, you naturally expect your salary to rise at least by 4% per year. To match the price rise, your salary at the end of 5 years should be 10000 x (1 + 4/100)5 = 12,160
Based on the above simple example, one thing is clear. A salary of 12,160 in 5 years from now is equivalent to a salary of 10,000 now.
Similarly, in discounted cash flow model, your objective is to calculate the present value of future cash flows. Therefore, you have to proportionately decrease the future cash flows based on the number of years. To do this, we use the formula,
Present of value of nth year Cash Flow = CFn / (1 + r)n
In the above formula, “r” is called the discount rate. This is the magic factor that will give you the present value of future cash flows.
Note: There is a direct relationship between discount rate and inflation rate. However, they are slightly different from each other. You need not worry about the differences now. All you have to understand is this:
As inflation rises, the discount rate rises too.
Now, let us get back to our DCF formula:
Intrinsic Value = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 + CF4/(1+r)4 + CF5/(1+r)5 + …
Did you notice an important problem with the above formula? At the end, there are three ellipses. This formula is a never-ending one (!?). Luckily, there is a workaround to make the formula handy and practical.
The workaround is to use the formula for 5 years and substituting the last term with something called terminal cash flow. (Terminal value can be found by a slight variation of the Gorden Formula.)
Now, assume you have estimated the cash flows for five years and know the discount rate. Now you can use the below modified formula to find the intrinsic value.
CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 + CF4/(1+r)4 + CF5/(1+r)5 + CF5(1 + g)/(r – g)
Note, the last term CF5(1 + g)/(r – g) is called the terminal value.
Now before proceeding further, let us break down the final term CF5(1 + g)/(r – g)
The terminal CF value is based on Gordon Model and calculates the present value of all cash flows after 5 years. This is super useful because you cannot go on estimating cash flows beyond 5 years. The primary reason is your accuracy decreases with time. You cannot foresee too much into future.
In CF5(1 + g)/(r – g), the value of g is the growth rate of cash flows after 5 years. Here you are assuming that after 5 years, the cash flow will grow at a constant rate ever (perpetuity).
Now if you have estimated the cash flows for 5 years, the discount rate and growth rate of cash flows, you can arrive at an intrinsic value. If you know the intrinsic value, you will know whether the stock is undervalued or not.
In purely mathematical terms, the meaning of undervalued stock when using DCF model is this:
Market Value < Intrinsic Value, which is CF1/1+r + CF2/(1+r)2 + CF3/(1+r)3 + CF4/(1+r)4 + CF5/(1+r)5 + CF5(1 + g)/(r - g)
Note: Since we are interested in intrinsic value per stock, you have to use cash flows per stock on the right-hand side of the formula.
A Simple Example
Now, let us calculate the intrinsic value for our example firm “Tasty Candy”.
Based on the information you have (including balance sheets, CEO speech, new products, new markets, etc), let us assume your estimates for 5-year cash flows are the following.
10000$, 10200$, 10404$, 10612$ and 10824$
Note: In the above example, we have just incremented the cash flow of every year by approximately 2% to arrive at the next year’s CF. But a real-life estimate will not be as simple as this. The estimated growth rate of cash flows need not be uniform for consecutive years.
Let the discount rate be 4% or 0.04.
Let g or growth rate of cash flow from the fifth year be 2%
Now, the intrinsic value of “Tasty Candy” can be calculated as shown below.
Intrinsic Value (for all stocks combined) = 10000 / (1 + 0.04) + 10200 / (1 + 0.04)2 + 10404 / (1 + 0.04)3 + 10612 / (1 + 0.04)4 + 10824 / (1 + 0.04)5 + 10824 (1 + 0.02)/(0.04 – 0.02)
= 9615.38 + 9430.47 + 9249.12 + 9071.18 + 8896.54 + 552024
Let us assume “Tasty Candy” has issued 100,000 shares. Therefore, intrinsic value per share = 598286.69 / 100,000 = $5.98
Therefore, if the share price of Tasty Candy is lesser than $5.98, you can call it an undervalued stock.
Note: We estimated the cash flows for 5 years before using the terminal value. But, you can change the forecast period depending upon the information you have in hand.
You are the best judge of the forecast period. For example, if you feel you cannot project the cash flows beyond 3 years, you can alter the formula accordingly. Now, the formula will become:
Intrinsic Value = CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 + CF3(1 + g)/(r – g)
5 Summary: Undervalued Stocks Meaning In 2 Different Cases
Now you know undervalued stocks have different definitions for companies that pay dividends and that don’t. Here is a quick summary to help you.
- For a large company paying dividends (usually blue-chip) the meaning of an undervalued stock is this – The present value of the stock is lesser than the sum of all future dividends discounted back in time.
- For a company that pays no dividends (usually growth, tech companies & new firms) the meaning of an undervalued stock is this – The present value of the stock is lesser than the sum of all future cash flows discounted back in time.
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