You notice that there is a stock being traded at ₹50. You come across a company where its stock is selling at ₹2,000. Which one would appear to be a better buy? In many cases, the answer is obvious – the ₹50 stock. However, it is important to understand that there is something wrong with this kind of logic. The price per share of stock cannot help you determine whether the stock is undervalued. Even a ₹50 stock may actually be overvalued, whereas the ₹2,000 stock may be fairly valued. That is why it is critical to take into account other factors in order to consider a stock a bargain.

Share Price Does Not Equal Company Value

The price of one share only tells you how much it costs to buy one share. It doesn’t tell you how much the entire company is worth.

Consider two companies:

Despite having a much lower share price, the market value of Company A is higher. Therefore, when looking at two stocks just in terms of share prices, one may easily get misled. The number of outstanding shares should also be considered.

Why a Low-Priced Stock May Have Weak Fundamentals

In some cases, the market may have doubts about a particular firm because of which it trades at a lower price. Some of the problems that the company faces may include declining sales, falling profitability, growing debt, poor cash flow, growing competition or issues in the respective sector. Consider a company that is trading at ₹50 when its share price was once ₹200.

If its profitability is dropping during that time, what if its debt is growing? What if its business operations are becoming less and less profitable as well? In such scenarios, the falling price may indicate a falling value of the underlying stock instead of providing a good investment opportunity. A falling stock price does not necessarily mean anything about the underlying firm.

Consider Market Capitalisation

The next step in valuing a stock would be looking at the market capitalisation of the company. The calculation of the market capitalisation of a company requires multiplication of the stock price with the total number of outstanding stocks of the company. By looking into market capitalisation, you get a far better idea of the market value of the company compared to simply looking at the stock prices. For instance, the market capitalisation of ₹100 stock having 1 crore outstanding shares is ₹100 crore. And that of ₹20 stock having 100 crore outstanding shares is ₹2,000 crore. This means the ₹20 stock does not necessarily have to be a “cheap” stock.

Evaluate the Company’s Earnings

If you want to figure out whether a particular stock is fairly priced, you will have to know the earnings of the company. Here come handy all those valuation ratios like Price-Earnings Ratio or P/E ratio.

For example, suppose two companies have similar businesses:

• Company A trades at a P/E of 10
• Company B trades at a P/E of 30

Valuation is higher for Company B relative to its earnings. But this does not necessarily imply that Company A is a better buy. Company B might have more growth opportunities, better margins or even be operating in a more competitive environment.
Valuations have to be considered within the context of company’s growth and financials and not in isolation.

Comparison of the Stock With Other Stocks

When trying to gauge the valuation of a firm, it helps to compare its financial metrics to those of similar firms. Assuming a stock has a P/E ratio of 15 while its competitors have an average P/E of 25. Then the stock appears cheaper in comparison. But then comes the question, why?
The reason behind the seemingly cheap stock could be due to slower growth rates, greater amounts of debt or poor profitability relative to its peers. If, however, the financial performance of the company is similar to or even better than that of its competitors, it would be worth considering the stock further.

Don’t Ignore Debt

Debt is another crucial variable that some investors overlook when looking for cheap stocks. In essence, a firm could have promising revenue and profit statistics but also has considerable debt. High debt level does not always translate to a negative signal. Firms might take up debts to grow their business by constructing new plants or making other investments. The problem occurs where a firm finds it challenging to manage the debt or cash flows are insufficient to meet financial requirements. Thus, when examining cheap stock, you should establish if debt levels are sustainable and if the financial situation of the firm is worsening or improving.

Check Cash Flows, not just Profits

Accounting profit is crucial when analyzing a firm but it only tells a fraction of the story. A firm could post positive accounting profits while producing poor or fluctuating cash flows. Good cash flows could matter due to the fact that firms require cash to operate, pay debts, make investment and eventually return cash to their shareholders. Therefore, don’t rely solely on the profit statistics, go ahead and examine the firm’s operating cash flows.

Fallen Stocks Aren’t Necessarily Bargains

One of the most common errors an investor makes is the belief that the fall in the stock price makes it look like a bargain. A fall from ₹1,000 to ₹500 would imply a cut by 50%. However, there’s no certainty that ₹500 is indeed the true value of the stock. If the earning power, competitive advantages or future prospects of the company haven’t improved, the stock might still continue to fall even further. This phenomenon is commonly known as catching a falling knife, i.e., buying the falling stock simply because of a fall in its price. The question shouldn’t be, “By how much has the stock fallen?”, but rather “Have the prospects for the company really changed?”

Avoid Making the Mistake of Mistaking Low Priced Stocks for Penny Stocks

Low priced stocks may prove tempting for some investors as they think that even small movements in the price will yield huge percentage returns. In the first example, a change in stock price from ₹10 to ₹20 would be an increase of 100%, whereas the second example represents an increase in price by just 1%, from ₹1,000 to ₹1,010. However, percentage return calculations are based on the price movement, rather than the initial stock price. Thus, it is possible for a ₹10 stock to fall to ₹5 as much as a ₹1,000 stock falling to ₹500. Low-priced stocks carry risks related to low liquidity, lack of information and poor performance.

So, What Makes a Stock Truly Cheap?

A stock can be considered potentially undervalued when its market price appears low relative to the value and future earnings potential of the underlying business. That requires looking at several factors together:

• Revenue and profit growth
• Profit margins
• Debt levels
• Cash flows
• Valuation ratios
• Industry and peer comparisons
• Competitive advantages
• Future growth prospects
• Overall business risks

No single metric can tell you whether a stock is worth buying.

The Price Isn’t the Whole Story

By far, the biggest blunder would be to base your investment decision on the price of the stock itself. Just because a stock is trading at ₹20 or ₹50 does not mean that it is cheap. Likewise, just because a stock is trading at ₹1,000 or ₹2,000, it is not necessarily an expensive stock. The bottom line is that you need to focus on the value of the underlying business and whether the stock is valued based on its performance. The next time you see a cheap looking stock, think twice before buying it.

For more market insights, trading resources and information to help you stay informed and make more considered decisions, explore Aetram.

FAQs

1. Is a low share price a sign that a stock is undervalued?
   No. Share price alone cannot determine whether a stock is undervalued. You need to consider the company’s market capitalisation, earnings, financial health, growth prospects and valuation.
2. What is more important than a stock’s share price?
   Factors such as the company’s fundamentals, valuation, profitability, debt, cash flows and future growth prospects are more useful when assessing whether a stock is attractively valued.
3. Can a stock with a high share price be cheaper than a low-priced stock?
   Yes. A higher share price doesn’t necessarily mean a higher valuation. The company’s total market value and earnings need to be considered.
4. What should I check before investing in a low-priced stock?
   Look at the company’s revenue and profit trends, debt, cash flows, valuation, industry position and future growth prospects rather than focusing only on its share price.
5. Should I buy a stock just because its price has fallen significantly?
   Not necessarily. A falling price could indicate that the market expects weaker future performance. Investors should understand why the stock has declined before considering whether it represents an attractive valuation.