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10 signals of a deeply undervalued stock

What do we understand by deeply undervalued stocks, India? These are stocks that hold huge potential for appreciation because they are quoting at a deep discount to the value imputed by the valuations. Legendary investors like Ben Graham and Warren Buffett have always spoken about picking undervalued stocks that can give huge capital appreciation over the years. The big question is how to find undervalued stocks, India and above all how do you decide whether the stock is an overvalued or undervalued stock? You can apply a 10-point test to get the answers. Remember, these are not points in isolation and typically a combination of 3-4 of these factors is what will make for an attractive buy.


1.  Is the business model disruptive enough?

Disruptive business is not only about finding products but also about a new market, a new market channel or even a new positioning. Look at how Eicher created value by positioning the company as a more trend producer of bikes rather than a drab maker of buses and MCVs. Similarly, back in 1990s, Infosys literally disrupted the global IT space by offering a high quality IT solution backed by a weak rupee and a positive tax environment. This not only helped Infosys to create wealth but the entire IT industry emerged as a $150 billion sector in India.


2.  Current Ratio of a stock

You may wonder; can current ratio really identify undervalued stocks? The answer is yes. What should be the Current ration in an ideal scenario? A current ratio of 1.25 is considered to be healthy and a current ratio of 1.75 to 2.25 may indicate that the company has a huge leeway to reduce its working capital allocation and relocate the capital to other productive uses. This ratio has to be used very cautiously after looking at the components of the ratio.


3.  Is the stock under leveraged in terms of debt

High debt stocks rarely create value in the markets. We have seen that in case of infrastructure stocks, power stocks and steel stocks. Over the last 10 years either they have given negative returns or deeply negative returns. Low debt with steady growth in revenues and profits is one of the best indicators of an undervalued company. In fact, this is one case where your estimate is very unlikely to go wrong.


4.  Is the stock having a very low cost of debt

Overall debt is one side of the story. The other side is the cost of debt. If the cost of debt is consistently coming down or if the interest coverage of the company is consistently and sharply going up, then it is a sign of an undervalued stocks. When you buy stocks with low debt or low cost of funds, you start with an advantage since financial risk plays to your advantage.


5.  Are we seeing sharp growth in earnings

This is normally the best signs of a stock that is turning around. The market is always willing to pay a premium for a stock where the earnings (top-line and bottom-line) is going to grow at a very rapid pace. That only means that the future growth in EPS will be combined with an upward re-rating of the P/E ratios. This is a fairly reliable indicator of stocks being undervalued.


6.  Is the ROE and ROE growing above the industry average

The two ratios that matter to stake holders is the ROE (Return on equity) and the ROCE (Return on capital employed). These ratios measure the returns that equity stakeholders and the debt stakeholders get respectively. Higher ROE combined with a higher retention ratio is what drives growth and P/E ratios of stocks. In fact, if the improvement in ROE is matched by an improvement n ROCE also, then it is a more convincing trigger.


7.  Clear signs of technical break out in the stock

These signs are more technical but when stocks break out of a long resistance after a very long time, one can look forward to a sharp up move. Remember; while this is a technical indicator, it is normally seen when there is a larger underlying fundamental story.


8.  Attractive PEG ratio

PEG ratio is an improvement over the PE ratio. The PE does not consider the growth rate of the company. For example, a stock may be undervalued at 15X P/E Ratio if the growth is 40% but a stock may be overvalued at 12X P/E Ratio if the growth rate is just 8%. It is this dichotomy that PEG ratio bridges.


9.  Very high dividend yield

This is a slightly debatable issue since high dividend yield is not associated with wealth creators. Investors have always high growth companies and that requires companies to plough most of their profits. A high dividend payout is indicative of a company that has limited investment opportunities and hence is payout dividends liberally. However, there is another side to this argument. High dividend yield also acts as a base for a company in the worst of markets and that makes it an attractive bet.


10.  Moat and margin of safety
Moat and margin of safety are common terms used by Warren Buffet. While moat reflects a unique advantage that the company may have built, the margin of safety captures the extent of undervaluation. The wider the margin of safety stronger is the case to invest in the stocks as an underpriced bet.
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