Advertisement
The term “growth stocks” generally refers to companies that are perceived to be growing faster than their counterparts within their industry, or, at the very least, the overall market. Growth stocks have always been the most desirable for investors that seek capital appreciation. However, all growth stocks are not created equal. Many times a stock is rendering continued undervaluation, considering even the longer-term prospects. It is these “undervalued growth stocks” that offer a good possibility for an astute investor who can find hidden value in them before the whole market becomes aware of it. The article explains what undervalued growth stocks are, how to identify one, and why they offer a good investment opportunity.
What is an Undervalued Growth Stock?
The undervalued growth stocks are those showing great growth potential but currently trading below their intrinsic value. That is to say, from the point of view of fundamental analysis, the prices of those stocks are below what would be expected based on future earnings and their positioning with regard to the competition. Undervalued growth stock should mean the market has not priced in the growth prospect of such a company, probably because such factors are temporary, due to market inefficiency, or simply investor sentiment.
While growth stocks are more romantically associated with the early stage of growth or with disruptive technologies, finding undervalued growth stocks is somewhat subtle. They may have shown some success already, though it is just that their future prospects have not been factored into the market as yet. Hence, finding such jewels requires a balancing act between considerations of growth indicators and valuation.
How to Find Undervalued Growth Stocks
As it befits such a wonderful concept, finding undervalued growth stocks is considerably more than the process of screening for companies with very high rates of revenue increases. This is complex analysis-not only of a company’s growth prospects, but also of its current market price in relation to its fundamentals. Some approaches to finding such stocks are presented below.
1. Price-to-Earnings/Growth Comparative Analysis
First of all, an undervalued stock generally can be known by its P/E ratio, which shows the relation between its price and earnings. A low P/E ratio is normally indicative of an undervalued stock with respect to earnings potential. If it is a growth stock, this has to be put into perspective with regard to the growth rate of the company.
A common metric applied here is the Price-to-Earnings-to-Growth ratio, or PEG, that adjusts the P/E ratio for the company’s expected earnings growth. A PEG below 1 is normally recognized as the sign that the stock is undervalued with respect to growth prospects. A stock with a low PEG ratio might be recording high growth and is trading relatively inexpensively. For example,
2. Strong Earnings Growth with High Margins
They should look at the firm’s ability to generate consistent profit growth. Despite cyclic challenges in certain industries, or even economic recessions, a number of firms still boast enviable earnings growth records. Companies of such a nature, which boast large profit margins and the ability to scale operations efficiently, tend to maintain their lead through time. This fact is irrespective of whether their stock is undervalued or not.
3. Industry Position and Competitive Advantage
Other aspects of corporate consideration would be the industrial standing of the company. A company which, due to some reason, may enjoy certain sustainable competitive advantage in terms of a unique product or advanced technology may also sustain long-term growth even at adverse market conditions. Growth stocks that are undervalued may fall through the cracks because sometimes investors either overlook the company’s long-term potential or become too engrossed with near-term market fluctuations.
4. Levels of Indebtedness and Financial Health
The full growth of a company may not be realized if its leverage is very high, since this reduces financial flexibility. Those companies that can have manageable debt and healthy balance sheets may be resilient during economic downturns. Therefore, investors should always scrutinize a company in depth based on its debt-to-equity ratio, current ratio, and other relevant financial indicators to make sure it is well-placed for growth.
5. Market Sentiment and Timing
Sometimes, a growth stock can only be undervalued because general market perception goes against its industry or sector. For instance, technology stocks can become undervalued on a general market sell-off or when investors think of the possibility of rate increases. If all the fundamental factors of the company remain strong and the market perception against it is adverse, that could be the best time to buy it at a discount.
Why Invest in Undervalued Growth Stocks?
There are some advantages of investing in underestimated growth stocks. Following are some of the solid reasons due to which such stocks may be included in any portfolio:
1. Can Move Up Substantially
The most alluring thing about undervalued growth stocks is the substantial capital appreciation they might offer. The price of the stock, once the market recognizes the potential of the company to grow, could skyrocket upwards very fast and give huge returns to the investors. It is an excellent avenue of investment when the stock is fundamentally good and just temporarily out of favor.
2. Less Chance of Overpaying
With undervalued stocks, the focus is on investment in those that are not yet overvalued because the valuations have outgrown the growth they are supposed to represent. Such stocks can be expected to rise but have not soared to those speculative levels some high-flying growth stocks have reached. There may even be some protection there because it is already trading below its intrinsic value.
3. Diversification in Growth Investing
Most growth stocks can come from just a few industries or sectors, such as technology, health care, and consumer discretionary. However, undervalued growth stocks can be a way to get exposure toward at least growth in un-flooded areas and may also round out a portfolio to reduce risk and position it well for gains.
Risks of Investing in Undervalued Growth Stocks
Like any investment strategy, there are some risks when trying to identify and invest in undervalued growth stocks. The most important point is that undervaluation may take longer to sort out than the investor expects. Another problem could be that the market is right, and such stock would not grow as expected.
This normally involves a lot of research and analysis in unearthing which growth stocks are undervalued. Mostly, due diligence becomes absolutely necessary to fathom the business model of a company, the strength of its finances, and its future prospects. This could be a very labor-intensive and somewhat complex process for an unsophisticated investor.
Conclusion
Undervalued growth stocks offer a rare opportunity to the investor seeking long-term capital appreciation without having to pay a premium for growth. Such stocks, promising to outperform the market once their real value is recognized, could be identified through keen observation of the financials of a company, its growth prospects, and its positioning in the market. Definitely a patience-demanding strategy, exhaustive research required, but highly rewarding provided one manages to discover them before they get fully valued in the market.
