When we talk of undervaluation and overvaluation, there are two principal approaches. There is undervaluation and overvaluation at the market level and then there is the overvaluation at the stock specific level. These are two different factors altogether. While finding underpriced stocks is a lot more tough and requires in depth study, finding out the underpricing in the market is a lot simpler. There are some basic parameters that can tell if the market overall is underpriced. You can start off by buying the index stocks to play on the market upturn. Let us now look at how to find undervalued stocks in 3 simple steps. We also look at an undervalued market scanner and an undervalued stock scanner. But most importantly, are there signs of undervalued stocks and undervalued markets? In fact, there are 7 such indicators that you must watch out for.
7 signals that the stock market is undervalued or underpriced
Firstly and foremost, you can buy into the market when the P/E is close to its historic lows. For example, the worst case P/E that the Nifty touched was around 10X back in 2003 and again in 2009. Both these situations came after a major carnage in the stock markets. With earnings continuing to growth, this created a big opportunity for investors to buy into the market. While you cannot catch the bottom of the market, any signal of P/E close to historical lows is a good entry point. For example, those who brought in to the markets in 2003 or in 2009 have seen many stocks become virtual multi-baggers over time. While P/E in specific stocks may go wrong, the P/E signals on the markets as a whole are rarely wrong.
Dividend yield is a good indicator and represents an underpriced market when it is very close to historical highs. Normally, higher the dividend yield more is the undervaluation of the market. Dividend yield is calculated by dividing the rupee dividend paid per share by the price per share. The Nifty has normally hovered in the dividend yield range of 1 to 1.3. However, at market bottoms, we have seen dividend yields go above the 2% mark. This is a classic case of undervaluation of the markets. While this may be impacted by factors like taxation of dividends and other specific factors, the dividend yield signal combined with the P/E signal is rarely misleading.
Stock prices are growing slower than earnings and that is good from valuation perspective. Earnings growth starts when the environment is conducive. Sales may be picking up or the profits may be rising due to lower costs as an outcome of fall in oil prices. In fact, a large part of the bull rally post 2014 was actually led by the lower costs of corporates due to cheaper oil. That improved profits despite difficult operating conditions and set the ground for the Nifty to rally above the 11,000 mark. Always keep an eye where earnings have started rising but markets are still not recognizing it.
Most retail investors are still bearish on the market. This sounds slightly ironic but it is the reality. Most retail investors tend to start buying when markets peak and tend to start selling when the markets have corrected sharply. Instead of getting fearful at market tops, they tend to get greedy. On the other hand, instead of getting greedy and buying at lower levels, retail investors tend to get fearful. Too much retail scepticism is a sure sign of markets bottoming out.
Market Cap / GDP ratio of less than 0.70 and GDP on a higher plane. Market cap is the value of all listed stocks. One can argue that market cap is a stock and GDP flow, but this is an internationally acclaimed measure. Then the Market Cap / GDP ratio falls below 0.70, it is a case of markets being undervalued. AT the same time, if the ratio is above 1.5, it could be a signal of markets being overvalued.
There has been a substantial infusion of liquidity in the markets. Markets rallied across the world post 2009 due to massive funds infusion by the central banks across the world. This led to a buying frenzy as the same stocks got more expensive. One can argue that market rallies driven by liquidity are not sustainable but that is a different argument altogether. Just as liquidity infusion is positive for stock market today, tightening of liquidity is a gross negative for the stock markets. Government has to be careful about too much liquidity as it can also stoke inflation. However tightening liquidity is not a situation that even the government prefers.
FIIs are buying aggressively in the markets and that is a kind of a sure short sign that markets are likely to pick up. Of course, FIIs also buy on momentum. But, normally there is aggressive buying by FIIs in the market only when there is a back of attractive valuations. That is the key!