What is an Undervalued stock?

An undervalued stock is defined as a stock that is selling at a price significantly below what is assumed to be its intrinsic value (finance). For example, if a stock is selling for $50, but can be determined to be worth $100 based on predictable future cash flows, then it is an undervalued stock.

Numerous popular books discuss undervalued stocks. Examples are The Intelligent Investor by Benjamin Graham, also known as "The Dean of Wall Street," and The Warren Buffett Way by Robert Hagstrom.

The Intelligent Investor puts forth Graham's principles that are based on mathematical calculations such as the price/earning ratio. He was less concerned with the qualitative aspects of a business such as the nature of a business and its management. Graham's ideas had a significant influence on the young Warren Buffett, who later became a famous US billionaire.

Warren Buffett, also known as "The Oracle of Omaha," stated that the value of a business is the sum of the cash flows over the life of the business discounted at an appropriate interest rate.[1] This is in reference to the ideas of John Burr Williams. Therefore, one would not be able to predict whether a stock is undervalued without predicting the future profits of a company and future interest rates. Buffett stated that he is interested in predicable businesses and he uses the interest rate on the 10-year treasury bond in his calculations.

Therefore, an investor has to be fairly certain that a company will be profitable in the future in order to consider it to be undervalued. For example, if a risky stock has a PE ratio of 5 and the company becomes bankrupt, this would not be an undervalued stock.

Some qualities of companies with undervalued stocks are:

• 1. The company's earnings history is stable.
• 2. The company does not specialize in high-technology that can become obsolete overnight.
• 3. The company is not in the middle of some financial scandal.
• 4. The company's low PE ratio is not due to profits realized from capital gains.
• 5. The company's low PE ratio is not due to a major decline in profitability.
• 6. The company's PE ratio is below its average PE ratio for the last 10 years.
• 7. The company is selling at a price below its tangible asset value.
• 8. The company's trailing 3-years earnings has risen over the past 10 years.
• 9. The company's credit rating is AAA, AA, or A.
• 10. The company did not have a loss during the last recession.

A excellent stock at a fair price is more likely to be undervalued than to a poor stock at a cheap price, according to Charles Munger, the Harvard educated partner of Buffett. An excellent stock continues to rise in value over the long term, while a poor stock declines in value.

An undervalued stock will usually have a low PE ratio. For example, a PE ratio of 10 is much better than a PE ratio of 20. Some high-flying Internet stocks had a PE ratios of 30, 40, 50, 100, 200 or more in year 2000, prior to the bursting of the Internet stock bubble. Investors of these Internet stocks did not purchase undervalued stocks, as they later learned.

The Intelligent Investor

The Intelligent Investor by Benjamin Graham, first published in 1949, is a widely acclaimed book on value investing, an investment approach Graham began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd. Famous investor and billionaire Warren Buffett describes it as "by far the best book on investing ever written"[1], a sentiment echoed by other Graham disciples such as Irving Kahn and Walter Schloss.

Mr. Market

Graham's favorite allegory is that of Mr. Market, an obliging fellow who turns up every day at the share holder's door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but sometimes it is ridiculous. The investor is free to either agree with his quoted price and trade with him, or ignore him completely. Mr. Market doesn't mind this, and will be back the following day to quote another price.

The point of this anecdote is that the investor should not regard the whims of Mr. Market as a determining factor in the value of the shares the investor owns. He should profit from market folly rather than participate in it. The investor is advised to concentrate on the real life performance of his companies and receiving dividends, rather than be too concerned with Mr. Market's often irrational behaviour.

What is the value of a stock?

"What counts, however, is intrinsic value - the figure indicating what all of our constituent businesses are rationally worth. With perfect foresight, this number can be calculated by taking all future cash flows of a business - in and out - and discounting them at prevailing interest rates. So valued, all businesses, from manufacturers of buggy whips to operators of cellular phones, become economic equals. "   -- Warren E. Buffett

In Stocks for the Long Run, Siegel gives annual returns for the period July 1963 to December 2000 (Table 8-2) for stock classified into size quintiles (small cap to large cap) and book-to-market quintiles (value to growth).

For small cap stocks returns vary significantly depending on book-to-market ratio. Growth stocks returned 6.41% per year compared with value stocks which returned 23.28%.

For large stocks the variation was smaller, value stocks returned 13.59% and growth stocks returned 10.28%.

Benjamin Graham  Benjamin Graham (May 8, 1894 – September 21, 1976) was an American economist and professional investor. Graham is considered the first proponent of Value Investing, an investment approach he began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd through various editions of their famous book Security Analysis. Disciples of value investing include Jean-Marie Eveillard, Warren Buffett, William J. Ruane, Irving Kahn, Hani M. Anklis, and Walter J. Schloss. Buffett, who credits Graham as grounding him with a sound intellectual investment framework, described him as the second most influential person in his life after his own father. In fact, Graham had such an overwhelming influence on his students that two of them, Buffett and Kahn, named their sons, Howard Graham Buffett and Thomas Graham Kahn, after him.

Graham was born in London and moved to New York with his family when he was one year old. Benjamin Graham was born Benjamin Grossbaum. After the death of his father and experiencing the humiliation of poverty, he became a good student, graduating from Columbia, as salutatorian of his class, at the age of 20. He received an invitation for employment as an instructor in English, Mathematics, and Philosophy, but took a job on Wall Street eventually starting the Graham-Newman Partnership.

His book, Security Analysis, with David Dodd, was published in 1934 and has been considered a bible for serious investors since it was written. It and The Intelligent Investor published in 1949 (4th revision, with Jason Zweig, 2003), are his two most widely acclaimed books. Warren Buffett describes The Intelligent Investor as "the best book about investing ever written."

Graham exhorted the stock market participant to first draw a fundamental distinction between investment and speculation. In Security Analysis, he proposed a clear definition of investment that was distinguished from what he deemed speculation. It read, "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

Graham wrote that the owner of equity stocks should regard them first and foremost as conferring part ownership of a business. With that perspective in mind, the stock owner should not be too concerned with erratic fluctuations in stock prices, since in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine (i.e. its true value will in the long run be reflected in its stock price).

Graham distinguished between the passive and the active investor. The passive investor, often referred to as a defensive investor, invests cautiously, looks for value stocks, and buys for the long term. The active investor, on the other hand, is one who has more time, interest, and possibly more specialized knowledge to seek out exceptional buys in the market.

Graham recommended that investors spend time and effort to analyze the financial state of companies. When a company is available on the market at a price which is at a discount to its intrinsic value, a "margin of safety" exists, which makes it suitable for investment.

Graham wrote that investment is most intelligent when it is most businesslike, a statement which Warren Buffett regarded as the most important words about investment ever written. Graham said that the stock investor is neither right nor wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.

Graham's favorite allegory is that of Mr. Market, a fellow who turns up every day at the stock holder's door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but often it is ridiculous. The investor is free to either agree with his quoted price and trade with him, or to ignore him completely. Mr. Market doesn't mind this, and will be back the following day to quote another price. The point is that the investor should not regard the whims of Mr. Market as determining the value of the shares that the investor owns. He should profit from market folly rather than participate in it. The investor is best off concentrating on the real life performance of his companies and receiving dividends, rather than being too concerned with Mr. Market's often irrational behavior.

Graham was critical of the corporations of his day for obfuscated and irregular financial reporting that made it difficult for investors to discern the true state of the business's finances. He was an advocate of dividend payments to shareholders rather than businesses keeping all of their profits as retained earnings. He also criticized those who advised that some types of stocks were a good buy at any price, because of the prospect of sustained stock price growth, without a good analysis of the business's actual financial condition. These observations remain extremely relevant today.

In recent years, Graham's "Mr. Market" approach has been challenged by Modern Portfolio Theory, as advanced by such proponents as William J. Bernstein, whose book The Intelligent Asset Allocator extends Graham's The Intelligent Investor via an appreciation of long-term trends and the near impossibility of understanding the market writ large. Modern Portfolio Theory posits that it is generally impossible for any individual to outwit the market, and is widely taught in American and British business schools. Nevertheless, Graham's approach retains a widespread and dedicated following. Indeed, numerous academic studies, including "Contrarian Investment, Extrapolation, and Risk", "Good news for value stocks: Further evidence on market efficiency", "The Cross Section of Expected Stock Returns", and many others, have proven that value stocks outperform the market over virtually all multi-year periods.

Tulip mania  was a period in the Dutch Golden Age during which contract prices for bulbs of the recently introduced tulip reached extraordinarily high levels and then suddenly collapsed.^[2] At the peak of tulip mania in February 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman. It is generally considered the first recorded speculative bubble (or economic bubble),^[3]Kipper- und Wipperzeit episode in 1619-22, a Europe-wide chain of debasement of the metal content of coins to fund warfare, featured mania-like similarities to a bubble.^[4] The term "tulip mania" is now often used metaphorically to refer to any large economic bubble (when asset prices deviate from intrinsic values).^[5] although some researchers have noted that the

Wall Street Crash of 1929

The Wall Street Crash of 1929 (October 1929), also known as the Great Crash, and the Stock Market Crash of 1929, was the most devastating stock market crash in the history of the United States, taking into consideration the full extent and duration of its fallout. The crash began a 10-year economic slump that affected all the Western industrialized countries.

“Anyone who bought stocks in mid-1929 and held onto them saw most of his or her adult life pass by before getting back to even.”  —Richard M. Salsman

Dow Jones Industrial, 1928-1930

The Roaring Twenties, the decade that led up to the Crash, was a time of wealth and excess. Despite caution of the dangers of speculation, many believed that the market could sustain high price levels. Shortly before the crash, economist Irving Fisher famously proclaimed, "Stock prices have reached what looks like a permanently high plateau." However, the optimism and financial gains of the great bull market were shattered on "Black Tuesday", October 29, 1929, when share prices on the New York Stock Exchange (NYSE) collapsed. Stock prices plummeted on that day, and continued to fall at an unprecedented rate for a full month.

In the days leading up to "Black Thursday" (called "Black Friday" in Europe due to the time difference) and "Black Tuesday" the following week, the market was severely unstable. Periods of selling and high volumes of trading were interspersed with brief periods of rising prices and recovery. Economist and author Jude Wanniski later correlated these swings with the prospects for passage of the Smoot–Hawley Tariff Act, which was then being debated in Congress. After the crash, the Dow Jones Industrial Average (DJIA) partially recovered in November–December 1929 and early 1930, only to reverse and crash again, reaching a low point of the great bear market in 1932. On July 8, 1932, the Dow reached its lowest level of the 20th century and did not return to pre-1929 levels until November 1954.

After a six-year run when the world saw the Dow Jones Industrial Average increase in value fivefold, prices peaked at 381.17 on September 3, 1929. The market then fell sharply for a month, losing 17% of its value on the initial leg down.

Prices then recovered more than half of the losses over the next week, only to turn back down immediately afterward. The decline then accelerated into the so-called "Black Thursday", October 24, 1929. A then-record number of 12.9 million shares were traded on that day.

At 1 p.m. on the same day (October 24), several leading Wall Street bankers met to find a solution to the panic and chaos on the trading floor. The meeting included Thomas W. Lamont, acting head of Morgan Bank; Albert Wiggin, head of the Chase National Bank; and Charles E. Mitchell, president of the National City Bank of New York. They chose Richard Whitney, vice president of the Exchange, to act on their behalf. With the bankers' financial resources behind him, Whitney placed a bid to purchase a large block of shares in U.S. Steel at a price well above the current market. As traders watched, Whitney then placed similar bids on other "blue chip" stocks. This tactic was similar to a tactic that ended the Panic of 1907, and succeeded in halting the slide that day. In this case, however, the respite was only temporary.

The trading floor of the New York Stock Exchange just after the crash of 1929

Over the weekend, the events were covered by the newspapers across the United States. On Monday, October 28, the first "Black Monday", more investors decided to get out of the market, and the slide continued with a record loss in the Dow for the day of 13%. The next day, "Black Tuesday", October 29, 1929, about 16 million shares were traded. The volume on stocks traded on October 29, 1929 was "...a record that was not broken for nearly 40 years, in 1968".  [Author Richard M. Salsman wrote that "on October 29—amid rumors that U.S. President Herbert Hoover would not veto the pending Hawley-Smoot Tariff bill—stock prices crashed even further". William C. Durant joined with members of the Rockefeller family and other financial giants to buy large quantities of stocks in order to demonstrate to the public their confidence in the market, but their efforts failed to stop the slide. The DJIA lost another 12% that day. The ticker did not stop running until about 7:45 that evening. The market lost $14 billion in value that day, bringing the loss for the week to $30 billion.

Dow Jones Industrial Average for 10/28/1929 and 10/29/1929

Date                    Change   % Change    Close
October 28, 1929    -38.33    -12.82       260.64
October 29, 1929    -30.57    -11.73       230.07

An interim bottom occurred on November 13 with the Dow closing at 198.60 that day. The market recovered for several months from that point, with the Dow reaching a secondary closing peak (i.e., bear market rally) of 294.07 on April 17, 1930. The market embarked on a steady slide in April 1931 that did not end until 1932 when the Dow closed at 41.22 on July 8, concluding a shattering 89% decline from the peak. This was the lowest the stock market had been since the 19th century.

Economic fundamentals

The crash followed a speculative boom that had taken hold in the late 1920s, which had led hundreds of thousands of Americans to invest heavily in the stock market. A significant number of them were borrowing money to buy more stocks. By August 1929, brokers were routinely lending small investors more than two thirds of the face value of the stocks they were buying. Over $8.5 billion was out on loan, more than the entire amount of currency circulating in the U.S. at the time. The rising share prices encouraged more people to invest; people hoped the share prices would rise further. Speculation thus fueled further rises and created an economic bubble. The average P/E (price to earnings) ratio of S&P Composite stocks was 32.6 in September 1929, clearly above historical norms. Most economists view this event as the most dramatic in modern economic history. On October 24, 1929, with the Dow just past its September 3 peak of 381.17, the market finally turned down, and panic selling started.

Subsequent actions

In 1932, the Pecora Commission was established by the U.S. Senate to study the causes of the crash. The U.S. Congress passed the Glass-Steagall Act in 1933, which mandated a separation between commercial banks, which take deposits and extend loans, and investment banks, which underwrite, issue, and distribute stocks, bonds, and other securities.

After the experience of the 1929 crash, stock markets around the world instituted measures to temporarily suspend trading in the event of rapid declines, claiming that the measures would prevent such panic sales. The one-day crash of Black Monday, October 19, 1987, however, was even more severe than the crash of 1929, when the Dow Jones Industrial Average fell a full 22.6%.

Effects and academic debate

Crowd at New York's American Union Bank during a bank run early in the Great Depression.

Together, the 1929 stock market crash and the Great Depression "...was the biggest financial crisis of the 20th century." "The panic of October 1929 has come to serve as a symbol of the economic contraction that gripped the world during the next decade." "The crash of 1929 caused 'fear mixed with a vertiginous disorientation', but 'shock was quickly cauterized with denial, both official and mass-delusional'." "The falls in share prices on October 24 and 29, 1929 ... were practically instantaneous in all financial markets, except Japan." The Wall Street Crash had a major impact on the U.S. and world economy, and it has been the source of intense academic debate—historical, economic and political—from its aftermath until the present day. "Some people believed that abuses by utility holding companies contributed to the Wall Street Crash of 1929 and the Depression that followed." "Many people blamed the crash on commercial banks that were too eager to put deposits at risk on the stock market."

"The 1929 crash brought the Roaring Twenties shuddering to a halt." As "tentatively expressed" by "economic historian Charles Kindleberger", in 1929 there was no "...lender of last resort effectively present", which, if it had existed and were "properly exercised", would have been "key in shortening the business slowdown[s] that normally follows financial crises." The crash marked the beginning of widespread and long-lasting consequences for the United States. The main question is: Did the "'29 Crash spark The Depression?", or did it merely coincide with the bursting of a credit-inspired economic bubble? Only 16% of American households were invested in the stock market within the United States during the period leading up to the depression, suggesting that the crash carried somewhat less of a weight in causing the depression.

Unemployed men march in Toronto, Ontario, Canada.

However, the psychological effects of the crash reverberated across the nation as business became aware of the difficulties in securing capital markets investments for new projects and expansions. Business uncertainty naturally affects job security for employees, and as the American worker (the consumer) faced uncertainty with regards to income, naturally the propensity to consume declined. The decline in stock prices caused bankruptcies and severe macroeconomic difficulties including contraction of credit, business closures, firing of workers, bank failures, decline of the money supply, and other economic depressing events. The resultant rise of mass unemployment is seen as a result of the crash, although the crash is by no means the sole event that contributed to the depression. The Wall Street Crash is usually seen as having the greatest impact on the events that followed and therefore is widely regarded as signaling the downward economic slide that initiated the Great Depression.

True or not, the consequences were dire for almost everybody. "Most academic experts agree on one aspect of the crash: It wiped out billions of dollars of wealth in one day, and this immediately depressed consumer buying."[29] The failure set off a worldwide run on US gold deposits (i.e., the dollar), and forced the Federal Reserve to raise interest rates into the slump. Some 4,000 banks and other lenders ultimately failed. Also, the uptick rule, which "...allowed short selling only when the last tick in a stock’s price was positive," "...was implemented after the 1929 market crash to prevent short sellers from driving the price of a stock down in a bear run."

Economists and historians disagree as to what role the crash played in subsequent economic, social, and political events. The Economist argued in a 1998 article, "Briefly, the Depression did not start with the stockmarket crash." Nor was it clear at the time of the crash that a depression was starting. On November 23, 1929, The Economist asked: "Can a very serious Stock Exchange collapse produce a serious setback to industry when industrial production is for the most part in a healthy and balanced condition? ... Experts are agreed that there must be some setback, but there is not yet sufficient evidence to prove that it will be long or that it need go to the length of producing a general industrial depression." But The Economist cautioned: "Some bank failures, no doubt, are also to be expected. In the circumstances will the banks have any margin left for financing commercial and industrial enterprises or will they not? The position of the banks is without doubt the key to the situation, and what this is going to be cannot be properly assessed until the dust has cleared away."

Many academics see the Wall Street Crash of 1929 as part of a historical process that was a part of the new theories of boom and bust. According to economists such as Joseph Schumpeter and Nikolai Kondratieff the crash was merely a historical event in the continuing process known as economic cycles. The impact of the crash was merely to increase the speed at which the cycle proceeded to its next level.

Milton Friedman's A Monetary History of the United States, co-written with Anna Schwartz, makes the argument that what made the "great contraction" so severe was not the downturn in the business cycle, trade protectionism, or the 1929 stock market crash. But instead what plunged the country into a deep depression, was the collapse of the banking system during three waves of panics over the 1930-33 period.