By and large, there are 3 simple ways of describing a company as undervalued. To define the term undervalued would to say that the stock market is offering you, a buyer, a price that is worth less than what the company is worth, in 3 ways:
1) By assets
This involves looking at the balance sheet of the company and assessing if the composition of the assets are sound, versus the liabilities listed. This also involved looking at the Notes listed afterwards for hidden liabilities, which can be law suits, or even leased items that can generate huge costs.
As most assets goes, usually the most "reliable assets" are ranked roughly as such,
i) Cash/Equivalents (bank deposits)
ii) Land/Property at cost
iii) Land/Property at fair value (market price, as valued by professional valuators)
iv) Accounts Receivable that are largely secured and not having a trend of increasing late payments, be it quantity or by days due.
The "unreliable assets" include
i) good will
ii) intangible assets
iii) assets classified as loans with dubiously high interest rate and/or unsecured.
iv) plants and equipment that are obsolete, or very little resale probability.
Catch: Companies who are human-capital intensive will fail to make the cut. Old companies with assets that are either depreciated (tangible assets) or amortized (intangible assets) will be screened out as well.
2) By Discounted Cash Flow valuation or sophisticated ways of quantitative valuation
Designed for companies with very consistent yearly cashflows and preferably consistent and low capital expenditures. The companies are assessed for its durable competitive advantage, which can be classified by
a) size of company in relative to competition
b) intangible/brand name assets that makes the end-user pay more solely for that.
c) unique access to a resource, either by geographical reasons or regulations.
d) high switching costs
An expected growth is computed for a defined number of years, and the total cash flow is discounted based on how risky the analyst think the company is. The number of cash generated is then divided by the amount of shares available and compared to the market price. If there is a significant difference in the favor of the buyer, this is constituted as "a margin of safety" and can be reliably purchased.
Catch:
a) Growth stocks will likely fail the cut, but discounted cash flow valuation is usually done by conservative investors anyway.
b) Companies who are by and large cyclical, that is, with earnings that are seasonal or project-based, will probably be hard to value.
If you are very lucky to get a company that is cheap based on (1) and (2), I regard that as a very safe purchase.
3) Cheap by Relative Valuation
By using this method, you are implicitly subscribing to this theory
that the markets are always efficient, in that the market always price
the stock correctly.
The last type of "cheap" companies are companies that are relatively cheap by comparison.
This involves comparing the company with
a) Its peers in the same industry and comparing their
i) Price to sales
ii) Price to cash flow
or even iii) Price to book value.
b) Ranking the companies in a reliable Index, such as S&P 500, Straits Time Index, FTSE, etc, and sorting them by its Price-to-Earnings or even just by the loss in price. The last few companies are then examine for its business qualities and then purchase. The idea is that the worst performers usually do well in the future.
I think this approach might be testy, and a lazy investor may be hurt very badly. Also, the market can be right at times, and companies can fall off the index due to failing to make the index's required market capitalization. Companies who suffer this fate usually don't recover largely because institutional buyers who not be interested in these companies, for fear of reprimands when the purchase don't bode well.
This is my opinion of how stocks are generally regarded as cheap, and my favorite approach is (1) and (2).
