The key to successful investment in the stock market is to identify and buy undervalued stocks and sell them at a high price in the near future. Fundamental valuation is the concept used to determine the intrinsic or true theoretical value of a stock. An undervalued stock is defined as a stock that has a market value below its true value. This is considered to be an anomaly and stock prices are expected to adjust to their true value in the next few days or months. Investors prefer to buy undervalued stocks to benefit from an increase in their price over subsequent days.
- Skill level:
Calculate the average growth rate in dividends over the past five years by using the arithmetic mean formula. For example, if the growth rate in dividends for the last five years as shown in the company annual reports is 5, 10, 10, 10 and 15 per cent, the average growth can be estimated by dividing the sum of growth rates by five. The average growth rate for this case is 10 per cent.
Multiply the prior year dividend by “1+growth rate” to estimate the expected dividend for the next year. For example, if the dividend paid by the firm in the previous year was 60p, the expected dividend for the coming year is $1.1.
Obtain the required rate of return on equity from a finance website such as Yahoo! Finance, MSN Money, or The Wall Street Journal. The required rate of return on each stock differs depending on the riskiness of the security. The riskier a stock is relative to the stock market, the higher the required rate of return for an investor. For example, the required rate of return on equity in this case is assumed at 14 per cent.
Estimate the true value of the stock by dividing the expected dividend for the next year, obtained in Step 2, by the required rate of return subtracted from the dividend growth rate. The estimated true value of the stock in the given example is [1.1/ (0.14-0.1)] £17.8.
Compare the true value for the stock obtained in Step 4 with the market value of the share to determine if it is undervalued or overvalued. If the market value for the share is £16, the stock is undervalued by £1.60. On the other hand, if the market value is £19, the stock is said to be overvalued. It is recommended to buy undervalued stock and sell overvalued shares.
Tips and warnings
- This is a popular method used by investment analysts for identifying undervalued stock.
- The true value for the stock is an estimate, not a guarantee that the stock will perform well. There is always uncertainty involved in stock market investments.
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