how to calculate undervalued stocks

A practical, beginner-friendly framework for how to calculate undervalued stocks using ratios, DCF, comparables and due diligence, with step-by-step checks, a worked example, and a concise formula ...

2025-09-21 06:18:00

By Lily Wong

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4.3

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How to Calculate Undervalued Stocks

Introduction

Understanding how to calculate undervalued stocks helps investors identify shares trading below their estimated intrinsic value — potential buying opportunities or ways to manage downside risk. This guide explains, in plain language, the common valuation approaches used for listed equities (for example, US-listed stocks), what inputs you need, step-by-step methods (including DCF and comparables), and practical checks to avoid common traps. If you want to learn how to calculate undervalued stocks for a specific name, this article gives the theory, tools, and a worked example you can follow end-to-end.

As of 2025-12-31, according to Reuters, market volatility and trading volumes have shown episodic spikes that make precise timing difficult; use valuation as a long-term decision tool rather than a short-term timing signal. (Source reporting date provided to give current market context.)

Note: the techniques below apply mainly to equities. Some ideas can be adapted for non-equity assets, but those require different assumptions and care.

Overview of valuation approaches

There are two broad valuation families you need to know when learning how to calculate undervalued stocks:

Intrinsic (absolute) valuation — estimates the company’s intrinsic worth based on expected future cash flows (the classic method is discounted cash flow, or DCF). Best for stable, cash-generative businesses where cash flow forecasts are meaningful.
Relative valuation — values a company by comparing its valuation multiples (P/E, EV/EBITDA, P/S, etc.) to peers or historical ranges. Best for cross-sectional screens and when comparability is clear.

Choose intrinsic methods when you can model cash flows with reasonable confidence; choose relative methods for quick screens or when businesses are similar and trading within a clear peer group.

Preparing for valuation

Inputs and reliable sources matter. Before you calculate undervalued stocks, gather:

Financial statements: income statement, balance sheet, cash-flow statement (most recent 3–5 years). Official sources: company filings (10-K, 10-Q for US firms) and investor presentations.
Analyst estimates: consensus revenue/earnings forecasts (useful for forward P/E and growth assumptions).
Industry data: margins, capital intensity, typical multiples for the sector.
Macroeconomic assumptions: risk-free rate, GDP growth, inflation for terminal growth choices.
Adjustment items: normalize earnings for one-time gains/losses, restructure charges, discontinued operations.

Common preprocessing steps

Adjust for non-recurring items and accounting quirks (reclassify unusual gains/losses).
Compute normalized margins (use average margins across cycle for cyclical firms).
Reconcile differing definitions of EBITDA, operating income, and free cash flow across sources.

Fundamental ratio analysis (Quick screens)

Valuation ratios are quick ways to flag potential undervaluation. They are screening tools, not final answers. Key ratios (one-line purpose each):

P/E (price-to-earnings): compares market price to net earnings — signal of earnings-based valuation.
P/B (price-to-book): measures price vs book value/share — useful for asset-backed or financial firms.
P/S (price-to-sales): shows valuation relative to revenue — helpful when earnings are negative.
EV/EBITDA (enterprise value to EBITDA): assesses firm value including debt vs operating earnings — good for cross-capital-structure comparison.
PEG (P/E-to-growth): adjusts P/E for expected earnings growth — helps judge if a high P/E is justified by growth.
Dividend yield: income measure for mature, dividend-paying companies — part of total shareholder return assessment.
Debt ratios (D/E): evaluate leverage and financial risk — high leverage can justify a valuation discount.

Always compare ratios to the company’s industry peers and to the company’s historical range to know whether a low multiple is really cheap or reflects legitimate weaknesses.

Price-to-Earnings (P/E) and Forward P/E

How to compute

Trailing P/E = Current share price / EPS (trailing twelve months).
Forward P/E = Current share price / Forecast EPS (next 12 months).

Interpretation and pitfalls

Low P/E may indicate undervaluation or low expected growth/cyclical earnings. High P/E can indicate growth expectations or overvaluation.
Trailing P/E reflects past performance; forward P/E depends on analyst forecasts and is sensitive to optimism.
Watch cyclical companies: earnings can swing, making P/E misleading at peaks/troughs.

Price-to-Book (P/B) and asset-based measures

When P/B matters

P/B = Market price per share / Book value per share.
Useful for banks, insurers, real-estate firms, and asset-heavy companies where balance-sheet assets and liquidation value matter.

Limitations

Intangible-heavy businesses (software, brands) often have low book value relative to intrinsic worth — P/B underestimates value.
Book value can be affected by historical accounting (depreciation policies) and does not reflect current market value of assets.

EV/EBITDA and enterprise multiples

Why use enterprise-value multiples

Enterprise value (EV) = Market cap + total debt + minority interest + preferred – cash.
EV/EBITDA = EV / EBITDA; it neutralizes capital structure and is better for comparing firms with different debt levels.
Useful in M&A context and when comparing cross-capitalization peers.

Careful with definitions of EBITDA, lease adjustments, and non-cash items across companies.

Growth-adjusted valuation metrics

PEG ratio and growth adjustments

PEG = (P/E) / (earnings growth rate %). If EPS growth is 10% and P/E is 15, PEG = 1.5.
A PEG near 1 is often cited as “fair” (rule of thumb), but interpretation depends on growth quality and risk.

Other growth adjustments

Normalize growth over multiple years (3–5 year CAGR) rather than relying on one-year spikes.
Adjust multiples for differences in margins, ROIC, and capital intensity relative to peers.

Cash-flow based valuation — Discounted Cash Flow (DCF)

Step-by-step DCF overview

Forecast Free Cash Flows (FCF): project free cash flows for an explicit forecast period (typically 5–10 years for stable firms).
Choose a terminal value method: perpetuity-growth (Gordon) or exit multiple approach.
Select a discount rate: use WACC (weighted average cost of capital) for firm-level cash flows or an appropriate equity discount rate for equity cash flows.
Discount forecasted FCF and terminal value to present value.
Sum the present values to get enterprise value; subtract net debt to derive equity value; divide by shares outstanding for per-share intrinsic value.

Why DCF matters

DCF captures the fundamental economics of a business (cash generation) and is less influenced by market noise.
It is sensitive to assumptions — small changes in discount rate, terminal growth, or margins can materially change intrinsic value.

Free Cash Flow (FCF) and owner earnings

Definitions

Common FCF definition: FCF = Operating cash flow – Capital expenditures (CapEx).
Owner earnings (Warren Buffett term) = Net income + Depreciation & amortization – CapEx – Working capital add-ons + other adjustments for recurring items.

Adjustments

Remove one-offs and cyclical distortions for a normalized FCF series.
For firms with acquisition-led growth, adjust for acquisition-related cash flows.

Choosing a discount rate and terminal growth

WACC basics

WACC = (E/V)*Re + (D/V)Rd(1 – tax rate), where Re = cost of equity, Rd = cost of debt, E = market equity value, D = market debt, V = E + D.
Cost of equity commonly uses the Capital Asset Pricing Model (CAPM): Re = Risk-free rate + Beta * Equity risk premium.

Terminal growth

Choose a conservative terminal growth rate — typically below long-run GDP growth and inflation (e.g., 0–3% depending on region).
For risky or cyclical firms, choose lower terminal growth or use a lower terminal multiple.

Impact

Discount rate and terminal growth are the largest levers in a DCF: higher discount rates and lower terminal growth reduce intrinsic value materially.

Sensitivity and scenario analysis

Best practice when you calculate undervalued stocks:

Run sensitivity tables for key inputs (discount rate, terminal growth, margin assumptions).
Produce conservative/base/optimistic scenarios to show a valuation range rather than a single point estimate.
Key drivers are revenue growth, operating margin, reinvestment rate (capex and working capital), discount rate, and terminal assumptions.

Asset-based and Graham-style valuations

Conservative benchmarks

Book value and liquidation value: floor estimates for asset-backed companies.
Net Current Asset Value (NCAV): current assets – total liabilities; used by Graham for distressed value investing.
Graham’s Number: a rule-of-thumb conservative fair value for typical stocks: sqrt(22.5 * EPS * Book Value per share) — a quick conservative check.

When asset methods excel

Useful for distressed firms, deep value, or asset-heavy industries (real estate, commodities, some manufacturing).
Less useful for modern tech firms with intangible assets and service-oriented business models.

Relative (comparable) valuation

How to run comparables

Select a peer group of firms with similar business models, geography, and size-adjusted comparability.
Choose appropriate multiples (P/E, EV/EBITDA, EV/Sales) based on the firm’s profit profile.
Use medians or percentiles across peers; adjust for company-specific differences in growth, margins, and leverage.
Apply the chosen multiple to your company’s metric (EPS, EBITDA, Sales) to derive an implied value.

Adjustments to comparables

If your company has higher growth than peers, apply a premium; if lower, apply a discount.
Account for differences in margin and capital intensity: two firms with same revenue can have very different profitability.

Quality, risk & adjustments

Valuation must integrate qualitative checks that affect the quantitative output. Consider:

Business moat: pricing power, network effects, switching costs.
Earnings quality: accruals, large non-cash items, aggressive revenue recognition.
Accounting practices: off-balance-sheet liabilities, lease capitalization, related-party transactions.
Capital structure: contingent liabilities, short-term liquidity, debt covenants.
Management and governance: insider share sales, compensation structures, track record.
Industry cyclicality and regulatory/legal risks that could justify discounts or premiums.

Incorporating dividends and shareholder returns

Dividend-based valuation

Dividend Discount Model (DDM) values stocks by discounting expected dividends.
DDM is most appropriate for mature, stable dividend-paying companies.

Buybacks and total shareholder return

Share buybacks reduce shares outstanding and increase per-share metrics — adjust share count in DCF to reflect buyback plans.
When valuing, consider combined yield from dividends + buyback-funded EPS accretion.

Valuation for different company types

Tailor your approach by company type:

High-growth tech firms: revenue multiples, EV/Sales, and scenario-based DCFs using probability-weighted outcomes; be cautious with P/B.
Cyclical companies: use normalized earnings over cycles and cyclically-adjusted P/E ratios.
Financial institutions: use P/B, ROE, and specialized metrics (tangible book value, net interest margins); EV multiples less useful.
Asset-heavy industries (mining, real estate): asset valuations, reserve valuations, and P/NAV are important.

Common pitfalls & limitations

Watch out for these common mistakes when you calculate undervalued stocks:

Overreliance on a single metric (e.g., P/E) without understanding context.
Ignoring industry cycles that distort earnings and multiples.
Optimistic forecast bias and anchoring to management guidance without scrutiny.
Misestimating discount rates or terminal growth — small errors compound in DCF.
Failing to account for dilution from options, convertibles, or future capital raises.
Overlooking off-balance-sheet items, pension shortfalls, or contingent liabilities.

Margin of safety and investment decision rules

What is margin of safety

Margin of safety = the percentage gap between your conservative estimate of intrinsic value and the market price; it protects against model error and unknown risks.

Practical thresholds

Value investors often look for 20–40% margin of safety depending on business quality and uncertainty.
Higher uncertainty or lower-quality businesses require larger margins.

Simple decision framework

Buy candidate: market price < conservative intrinsic value × (1 – margin of safety) AND qualitative checks pass.
Hold: price within margin-of-safety band or more information needed.
Sell/avoid: price > base-case intrinsic value, or material qualitative risks exist.

Tools, data sources, and screening techniques

Common tools and data sources

Company filings (10-K, 10-Q), investor presentations, and press releases.
Financial data providers and terminals for multiples and consensus estimates.
Broker research, industry reports, and regulatory filings for peers and sector context.
Stock screeners to find low multiples + improving fundamentals.

Example screen to find undervalued stocks

Low forward EV/EBITDA percentile within industry + positive free cash flow + decreasing leverage over last 12 months.
Or: P/E below 1.5x industry median + PEG < 1 + stable margins.

Illustrative worked example (step-by-step)

This section describes what a worked example should include so you can reproduce it. For a full hands-on exercise, pick a listed company, then:

Select a company and download 5 years of financial statements from filings.
Calculate historical revenue, EBIT, EBITDA, capex, and free cash flow.
Compute key ratios: trailing P/E, forward P/E, EV/EBITDA, P/B, P/S, ROIC, D/E.
Build a simple DCF:
- Project revenue growth for 5 years with gradually improving margins.
- Estimate FCF each year = EBIT*(1 – tax rate) + D&A – CapEx – ΔWorkingCapital.
- Choose WACC and terminal growth (conservative).
- Discount cash flows and compute per-share intrinsic value.
Run sensitivity: vary WACC ±1% and terminal growth ±0.5% to show range.
Compare implied multiples to peers and reconcile differences.

A worked example helps demonstrate how ratio screens, DCF results, and comparables fit together to form a final view.

Applicability to cryptocurrencies and non-equity assets (brief note)

Most standard equity valuation methods rely on future cash flows, so they do not directly apply to most cryptocurrencies that lack cash-flow streams. For tokens, alternative approaches include:

Network value to transactions (NVT) ratios — comparing market cap to on-chain transaction value.
Tokenomics analysis — supply schedule, staking rewards, burn mechanisms, and velocity.
Usage and adoption metrics — wallet growth, active addresses, protocol fees.

These adapted approaches require domain expertise and different data sources (on-chain analytics) and should be treated separately from stock valuation.