One of the rules of stock investing is that you want to buy a stock at a good price. It’s important to make sure that you are getting a good deal. If you pay too much for a dividend stock – or any stock – it could come back to haunt you, especially if the value doesn’t appreciate as you would expect. An undervalued stock, though, can make a great addition to your portfolio.
An undervalued stock is one that has a price that is considered low as compared to its intrinsic value. This means that a stock might considered “worth” $50 a share, but that, on the market, it is priced at $30 a share. The stock is undervalued, since, if you take into account the possibility of future cash flow, and the growth of the company, it should be priced higher.
Unfortunately, it can be difficult to determine whether or not a dividend stock is undervalued. Just having a low price isn’t enough to say that a stock is undervalued. There are plenty of low-priced stocks that “deserve” those prices. They might be declining in value due to any number of issues, none of them related to the fact that the business is a solid one with good future potential. Buying a low-priced stock just because it is cheap can be one way to see losses down the road. A poor stock choice will continue to lose value, now matter how “bargain” the price appears now.
How Can You Tell if a Stock is Undervalued?
As with most subjects related to investing, there is no sure-fire way to ensure that you are purchasing an undervalued stock vs. a cheap stock. However, there are some clues that, combined, can help you figure out if a stock is undervalued:
- P/E ratio: The price to earnings ratio is a popular measure of stock value. The lower the number is, the better the valuation. So, a stock with a P/E ratio of 5 is better than one with a value of 10. However, you have to dig a little deeper. Why is the P/E ratio so favorable? If the P/E ratio comes as a result of a decline in profitability, or if it is realized through capital gains profits, the stock may not be undervalued after all.
- Good credit rating: While ratings agencies do have their weaknesses, a credit rating can be an indication of the financial health of a company. A company with a good credit rating, and/or low debt levels, could be undervalued.
- Stable earnings history: Many “boring” companies don’t always get the credit they deserve as solid investments. As a result, they might be priced lower than their value would suggest they should be. Look at the trailing three-year earnings, and whether they have risen, on average, over the last 10 years.
- Dividend payouts: You can also look at dividend payouts. Have they been steady over time? If so, it could be an indication of a strong company that is undervalued.
There is no way to guarantee that you are getting the best possible value when you invest in any dividend stock. But you can do your homework and increase the likelihood that you will buy an undervalued stock.