You have been following a particular stock for weeks. You have liked the company, studied the company’s performance and have thought about buying it, but the price was too high. One day, the stock comes down in price. This seems like the opportunity that you were looking for. The price is now low, the stock is relatively inexpensive and you are tempted to invest in the stock before it rises again. However, there is a catch: not all stocks that fall in price make good investments. The drop in prices might just be a market correction or it may point towards problems with the company. Knowing the difference between the two will help you avoid buying the stock purely on the basis of its low price.

So, when a stock that you have been eyeing falls in price, should you buy it? Let us find out.

Why Has the Price Fallen?

When trying to buy a stock after it falls, one must know why the price is falling. The fall in price does not always have the same significance.

• Prices Are Falling All Over the Market
  Sometimes, the stock falls in value simply because the overall market is performing poorly. Reasons behind the poor performance might include the general uncertainty in the world, high inflation rates, change in interest rates or investor pessimism. While the fall in the stock’s value might be a chance to reevaluate the stock if the business performance stays good, a fall in the overall market might continue longer than expected.

• The Company Has Poor Results
  In case a stock falls because of poor results of the company, the investor should check whether such a problem is a temporary one or if it is a sign of some bigger troubles. For instance, there might be a one-off expense that influences the quarterly results of the company, but does not affect its future perspectives. A decline in revenues, profit margins or increase in debt are additional signs for caution.

• Something Went Wrong in the Business
  There are situations when a problem is more severe. For example, a company may lose market share, face regulatory issues, have managerial problems or lose any other competitive advantages. If the initial reasons for buying the stock are not valid anymore, the price will not matter even if it is low. The question is not in how much the stock fell. It is about why the stock fell.

 1. Verify That the Stock Is Indeed Under Valued

If the share price drops from ₹500 to ₹400, there may appear to be a bargain to be had. However, that may not necessarily be the case. For example:

In this instance, the share price has dropped by 20% but it is earnings per share that has dropped as well. This means that the P/E ratio has now gone up to 25. The example shows why low share prices do not necessarily imply a good valuation. In order to judge whether a stock is worth your money after falling in price, look at earnings, potential for future growth and valuation ratios. The ratios like P/E ratio may be helpful but don’t look at just one number.

2. Review What Led You to Invest in It

Remember why the stock seemed attractive to you in the first place. Maybe you wanted to invest in this company due to its consistent earnings growth, great competitive advantage, solid future potential or simply rising stock price? Consider all these factors again.
Verify that the company continues to have:

• A viable business model
• Sound revenue and earning potential
• Controllable level of debt
• Competitive standing within its industry
• An appropriate valuation in light of its prospects

In case the original reasons for investing are still applicable, then the downturn might warrant some more research. Otherwise, if the business has gone bad, then buying simply because the stock is cheap may be exposing yourself to unnecessary risks.

3. Do Not Panic When There Is a Crash in the Market

When there is a drop in stocks, people will have this question: have they managed to catch the bottom of the market? But no one knows how to do it all the time. The stock that dropped from ₹500 to ₹400 might go even lower, to ₹350 or ₹300 and it might go up the very next day. Instead of looking for the best prices, just think about whether the investment is worth what it is now.
Sometimes investors prefer to buy stocks gradually because of their investment policies and financial situations.

4. Compare It With Other Investment Alternatives

Your interest in the stock might simply be because you have been watching it for some time now. That doesn’t necessarily make it the best investment alternative around. The stock should be compared with the valuation, profitability, future growth potential and financial risks of other businesses. This is because one company might be selling at a lower P/E ratio due to low profits while another has a high P/E ratio because of its success.
It is not about choosing the cheapest stock but rather making sure that the stock’s price matches up with its potential and risks.

5. Know Your Investment Time Frame

An investor’s investment time frame will dictate the manner in which one reacts to an occurrence where prices are falling. For an investor with a long-term objective, it will not necessarily be the volatility that will be the major factor but rather the ability of the firm to earn profits sustainably.
However, having a long time frame does not mean that a fundamentally bad company is worth investing in. On the other hand, if one is purchasing for short-term gain, then there is a need to factor in such things as prices trends, trading volumes, support and resistance levels, as well as the danger of further losses.

6. Determine Your Risk Tolerance Before Purchasing

Even when thoroughly analyzed, a stock can decline more than projected.
Before investing, determine how much risk you are willing to take regarding this investment and whether it fits your entire portfolio. Some considerations include:

• Will this move lower affect my fundamental necessities?
• Do I have too much exposure to one stock?
• Are there any other events that could lead to a change of opinion on this investment?
• Am I ready for the potential of having to wait for a very long time before it recovers?
• Does this investment match my goals and risk appetite?

For traders, pre-determined stop loss points and position sizes can assist in the management of risks. Investors on the other hand could be looking at changes in the company fundamentals, valuation and reasons for the initial investment. Never borrow money to invest simply because the stock is cheap.

Quick Questions You Must Ask Before Buying a Falling Stock

Before buying the stock, you must be sure whether:

• I know the reasons behind the fall in the stock price.
• The company’s financial results have been evaluated recently.
• The valuation of the stock is justified now.
• The initial reason to buy the stock holds good.
• Similar companies have been analyzed.
• The stock suits my investment period.
• I can bear the risks of lower stock prices.

If not, then don’t jump to purchase the stock.

A Price Fall Is the Time to Look for Answers, Not Necessarily to Buy

If the share which you have been eyeing falls in price, it is as if the market is giving you a chance again. Indeed, sometimes, this fall may present an ideal buying opportunity. However, in other cases, it may be a sign of underlying issues that need to be addressed. This can only be determined by looking at the fundamentals of the business in question, its present valuation and suitability of the investment for your purposes.
Do not buy shares simply because their price fell. Do so only after you have figured out what the business is worth, why the price has fallen and how risky the venture might be.

For more stock market insights, investing resources and tools to support your market analysis, explore Aetram.

FAQs

1. Should I buy a stock immediately after its price falls?
   Not necessarily. First, understand why the stock has fallen, review its financial performance and assess whether its current valuation is reasonable. A price decline alone isn’t a sufficient reason to buy.
2. How do I know if a falling stock is undervalued?
   Examine its earnings, growth prospects, debt, cash flow and valuation ratios. Compare the company with similar businesses and assess whether the decline reflects temporary market sentiment or weaker fundamentals.
3. Is buying the dip a good investment strategy?
   Buying the dip can be useful when a stock’s valuation becomes more attractive and its fundamentals remain sound. However, prices can fall further, so the strategy requires research, risk management and patience.
4. Should I buy more shares if my stock keeps falling?
   Not automatically. Reassess the company’s fundamentals, valuation and your portfolio exposure before adding to your position. Buying more simply to reduce your average purchase price can increase your losses if the business continues to deteriorate.
5. How much should I invest in a stock that has fallen?
   The amount should depend on your financial goals, risk tolerance, portfolio diversification and investment horizon. Avoid concentrating too much of your portfolio in one stock or investing money you may need soon.