Stock Undervaluation: What Is It and What Causes It? MintGenie explains

When shares or other securities of a firm are exchanged at a market price less than their intrinsic value, it is known as devaluation of the shares. Financial statements, cash flow, earnings, capital managed and return on assets can all be used to evaluate the intrinsic value of shares based on a company’s fundamentals.

Investors are often looking to buy low-priced stocks. The theory behind this is that profit opportunities will arise when market prices adjust over time to reflect the fair value of an asset. Finding undervalued stocks requires more than just locating cheap stocks. Instead of buying worthless stocks at a steep discount, look for high quality stocks that are trading below their true value. The key difference is that over time, higher quality equities will increase in value.

But why the shares were undervalued is the real mystery. This can often happen for a number of reasons. Let us decode the reasons behind this.

negative publicity

The value of a company’s stock always decreases when it finds itself in a situation that generates negative media attention. Meanwhile, this kind of negative publicity is just one of the many obstacles a company must face and overcome. The momentary loss of share value of such coverage is not always an indication that it will collapse completely.

market trends

Investors are urged to transact according to the market trend and accordingly take decisions regarding sale or acquisition of assets. When the overall momentum of the market is high, investors queue up to buy shares, and because of the herd mentality, they join in to sell shares when they are down. As a result, the shares are undervalued.

overall economic condition

When a nation’s economic indicators are unfavourable, the market as a whole tends to weaken, which is perhaps the most common reason for stock devaluation. These unfavorable conditions lead to a fall in the market value of many stocks. To estimate the value of shares, investors must have a basic knowledge and understanding of the state of the economy.

cyclic behavior

The shares of a corporation are valued according to its profits. Because of the company’s production and sales seasons, they are often cyclical. Additionally, a cyclical pattern can be observed in the demand for its goods and services. Therefore, even if such a company has solid fundamentals, its share price will fall during declining sales and rise again when its earnings increase.

price earning ratio

A corporation’s price-to-earnings ratio reflects the share price in relation to the income that is attributable to that share from the equity capital raised by the company. A high P/E ratio indicates that the price of the stock will exceed the earnings it generates. On the other hand, a lower P/E indicates higher earnings relative to the purchase price of the stock.

There is no guarantee that what some people underestimate will be seen by others in that light. There is no guarantee that the price of a stock will ever rise to what some investors consider to be a fair value, so buying cheap stocks isn’t always a good deal. Investors should do their research before investing in them.

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