Spotting undervalued stocks can help traders and investors find opportunities where a company’s share price doesn’t fully reflect its true worth. This guide explains what undervalued shares are, why they occur, and eight key financial ratios often used to identify them – plus how you can trade or invest in these shares with us. 

How to trade or invest in undervalued stocks with us

1. Create an account or log in 
2. Search for your preferred stock on our platform 
3. Select ‘buy’ or ‘sell’ in the deal ticket 
4. choose the number of shares you want to trade or invest
5. Open and monitor your position   

You can either trade or invest in undervalued stocks. When you invest you’re buying stock outright and taking direct ownership. You could receive dividends if the company grants them, and you’ll also get voting rights. Once you open an account with us, you can invest in US shares from zero commission or UK shares from £3 commission.

You can trade undervalued stocks via leveraged derivatives, namely spread bets and CFDs. You won’t take ownership of any shares, and you can speculate on rising or falling share prices.

Please note that trading on leverage magnifies your risk, because your profits and losses are both calculated on the full value of your position – not the deposit used to open it. Always take appropriate steps to manage your risk before committing your capital. 

See our costs and charges here. 

What are undervalued stocks?

Undervalued stocks are shares that appear to be trading below what’s considered their fair value. In other words, the price is lower than the company’s underlying worth based on its fundamentals. 

This difference can arise for many reasons: market volatility, negative headlines, or short-term economic uncertainty. However, over time, some investors expect that the market may adjust to reflect a company’s true performance and outlook. 

Finding undervalued stocks isn’t about looking for the cheapest shares on the market. Instead, it’s about identifying quality companies that may be temporarily mispriced based on their earnings, assets or future potential. 

If you’re exploring this strategy, it’s important to base decisions on verified financial data rather than personal opinions. Learn more about fundamental analysis and how it can help you assess a company’s value. 

Why do stocks become undervalued?

A company’s share price can fall below its perceived fair value for several reasons, including: 

• Market movements: Sharp market corrections or economic downturns can push even strong companies’ share prices lower. 
• Negative sentiment: News stories or broader political and social events can temporarily impact confidence in specific sectors. 
• Cyclical trends: Some industries, such as retail or travel, naturally experience periods of weaker performance. 
• Unexpected results: When a company’s earnings or forecasts don’t meet expectations, its share price may dip. 

Understanding why a stock is undervalued is as important as identifying that it is. After all, not all low valuations indicate future potential. 

Eight ways to spot undervalued stocks 

So, how do traders spot undervalued stocks? Most traders use financial ratios as part of their research into undervalued or mispriced companies. Below are eight of the most common measures used to assess value. 

(Note: Ratios can vary significantly by sector, so always compare companies within the same industry.) 

1. Price-to-earnings ratio (P/E) 
2. Debt-equity ratio (D/E) 
3. Return on equity (ROE) 
4. Earnings yield 
5. Dividend yield 
6. Current ratio 
7. Price-earnings to growth ratio (PEG) 
8. Price-to-book ratio (P/B) 

In the section below, we look at each of these in detail. Keep in mind that a ‘good’ ratio will vary by industry or sector, as they all have different competitive pressures. 

Price-to-earnings ratio (P/E)

The P/E ratio measures how much investors are willing to pay for each unit of a company’s earnings. It’s calculated by dividing the share price by the earnings per share (EPS). 

A lower P/E ratio may suggest a company’s shares are undervalued compared to its earnings, though it can also reflect market caution or slowing growth. 

Example: If a company trades at £50 per share, earns £10 per share in profit, and has a P/E ratio of 5, this means investors are paying £5 for every £1 of profit. 

Debt-equity ratio (D/E)

This ratio compares a company’s total liabilities with its shareholder equity. A high D/E ratio may indicate that a company relies heavily on borrowing, while a lower ratio suggests more conservative financing. 

However, what counts as “high” varies by industry. For instance, utility companies often carry more debt than technology firms. 

Formula: Debt-to-equity = Total liabilities ÷ Shareholder equity 

Return on equity (ROE) 

ROE measures how effectively a company generates profit from shareholders’ investments. It’s expressed as a percentage by dividing net income by shareholder equity. 

A higher ROE can indicate that a company is efficiently using capital, but it should be compared to competitors in the same sector. 

Example: If a company reports £90 million in net income and has £500 million in shareholder equity, its ROE would be 18%. 

Earnings yield 

Earnings yield is the inverse of the P/E ratio, showing the percentage return a company generates relative to its share price. It’s calculated by dividing EPS by the share price. 

Some investors view a higher earnings yield as a sign that a stock could be undervalued, especially compared to other investment returns available in the market. 

Example: If a company earns £10 per share and the current price is £50, the earnings yield is 20%. 

Dividend yield

This ratio measures a company’s annual dividend payments relative to its current share price. It’s found by dividing the annual dividend per share by the share price. 

Companies with consistent or growing dividend yields can appeal to investors seeking income as well as potential long-term value – though high yields can sometimes signal risk. 

Example: If a company pays £5 in dividends per share annually and the share price is £50, the dividend yield is 10%. 

You can explore how dividends work in our dividend stocks guide. 

Current ratio

The current ratio evaluates a company’s ability to meet short-term obligations, calculated as current assets divided by current liabilities. 

A ratio below 1 suggests a company may struggle to cover debts due within a year, while a ratio comfortably above 1 can indicate financial stability. 

Example: If a firm holds £1.2 billion in assets and £1 billion in liabilities, its current ratio is 1.2. 

Price-earnings to growth ratio (PEG)

The PEG ratio refines the P/E ratio by factoring in earnings growth. It’s calculated by dividing the P/E ratio by the company’s annual EPS growth rate. 

A lower PEG ratio could suggest that a company’s shares are undervalued relative to its growth potential. 

Example: If a company has a P/E ratio of 5 and an annual earnings growth rate of 20%, the PEG ratio would be 0.25. 

Price-to-book ratio (P/B)

This ratio compares a company’s market price per share with its book value per share (calculated as assets minus liabilities, divided by shares issued). 

A P/B ratio below 1 may indicate that a company’s shares are trading for less than the value of its assets, though this varies by sector. 

Example: If a company’s shares are priced at £50 and its book value per share is £70, the P/B ratio is 0.71. 

Summary

Understanding what makes a stock undervalued and how to evaluate it using financial ratios can help you make more informed decisions about potential opportunities. Whether you’re trading short-term price movements or investing for the long term, thorough research and risk management are essential. 

Start exploring undervalued stocks UK investors are watching today with an IG trading or investing account. 

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