By definition, a stock or equity means a stake in the ownership of a company. Equity is a means to raise capital for the corporate bodies. Equity holders of a company are the actual owners and can have say in the

Firm's operations through voting rights in the general body meeting. Though equity holders are actual owners of the net profits earned by a company for a year, the entire profit is not distributed among the owners, as some of it is retained back by the company management for capital investment required for the growth of the company and hence scope for increase in the wealth of the share holders. Remaining portion of the profit is paid amongst the investors as dividends. Once a company lists a portion of its total equity-base in stock exchanges, common public can also participate in buying and selling of its stocks and be eligible for dividends. But more than dividends, what attracts the investors to stock investments is the expectation of capital appreciation. The capital appreciation in the stock price enables investors to sell off their stocks in the market at a much higher price than what they bought them for, thereby making profits.

But not always, and not all stocks appreciate in price and so are the case that not all investors get to reap a positive return of capital appreciation of stocks. Because of this risky nature of stock investment, Investors need to have the foresight and prudence to select stocks that are more likely to appreciate in price V though the horizon may range between long and short terms.

So, how does one know which stocks are likely to go up in value Or, putting in differently, how investor knows which stocks are undervalued and which stocks are over valued so that he/she may chose the undervalued stocks to invest in. Let us look at some of the primary features / trends of undervalued stocks.

1. Undervalued stocks have a low price/earning multiple.

2. The price of undervalued stock is influenced by a few short- term factors.

3. Due to point 2 above, there is uncertainty regarding the near term results

4. One or more fundamental values of the stock / company which is/are going through a low is/ are likely to improve.

5. The company fundamentals are as sound as similar stocks with higher P/E multiple.

Undervalued stocks are also known as a challenge stock - stocks that can help in building a portfolio of stocks or

improve a portfolios projected average return due to the very natures described above.

With this background, now let us look at the importance of P/E multiple in determining how undervalued or over-valued a stock is.

P/E Multiple

The P/E ratio is given by the below formulae,

P/E = Price per share / Earnings per share

In the above formulae, the price per share is the market price of a single share determined by the forces of demand and supply at a given time, and the earning per share (EPS) is the net income of a company for the last financial year, divided by the number of outstanding shares. The EPS is the proportion of the net income (profit after tax) of the company that each investor earns during a given time period.

The P/E ratio gives the relationship between the market price of the stock and its earnings by revealing how earnings affect the market price of the firm's stock. If a stock has a low P/E multiple, for example 4/1, it may be considered as an undervalued stock. If the ratio is 30/1, it may be viewed as overvalued. The P/E ratio is a popular financial ratio and proves to be useful as long as the firm is a viable business entity and its real value is reflected in its profits. This ratio can be used to compare one stock with another based on the value of the multiple, but care should be taken to ensure that both the stocks are comparable stocks, having similarity in time periods, industries and countries. This comparison principle for undervalued/ overvalued concept is very critical, since P/E ratio in isolation will not convey the full picture of current valuation of the stock. A comparison with similar stock can give a better picture assuming / considering that the comparable stock is properly valued. Whatever be the case, the fact remains that if P/E of two comparable stocks has large difference, one of the stocks will be under or over valued.

Going ahead from the above discussion, now let us have a discussion as what an investor should look into to spot a truly undervalued stock.

Characteristics of Undervalued stocks

An undervalued stock is characterized by the presence of a low P/E multiple. But a low P/E ratio alone cannot give an investor idea about the real value of a stock. Investors need to have the foresight and prudence to study the fundamentals of the company they are going to invest in ,and thereby come up with an E(P/E) multiple. This is the P/E multiple investors expect to have based on the cash flows that the firm is likely to generate in the future years to be discounted at an appropriate rate.

To establish an appropriate price-earnings ratio for a given share, the following factors related to the firm need to be looked into-

Growth rate

Stability of earnings

Size of the company

Quality of management

Dividend pay out ratio

The cash flows of a company is determined by all the factors mentioned above. However, for a common investor it may be beyond his skills and expertise to analyse cash flows and determine an earnings scenario for a company. Never the less, it will always be wise for the investor to even intuitively analyse the above mentioned factors to understand the financial health of the company and have better picture of P/E ratio.

To continue with the E(P/E) discussion, if a firm has a high growth rate with stable earnings, it would surely mean a higher P/E multiple since the net income divided by outstanding shares give us the earning per share. The demand and supply interaction will push up the current price of the share. The higher the size of the company and the dividend pay out ratio, the higher will be the P/E multiple.

After arriving at an E(P/E) multiple based on the fundamentals of the company, investors need to observe the stocks current P/E by checking price and earnings data in websites, newspapers and financial periodicals.

If the E(P/E) exceeds the actual P/E substantially, and also similar stocks with healthy future outlook has higher P/E, the stock is currently under priced and its the right time to buy the share. But if the E(P/E) is much less than the actual P/E, and so is the case of P/E of similar healthy shares, the stock is currently overpriced and it may be the best time that you sell it and count the profits, and invest in some of the other shares from the same sector which are undervalued .