When it comes to smart investing and the world of savvy asset management, it’s paramount to ensure that the right amount of money is going into the right assets, whether you’re investing in real estate, resources or another industry.
Most investors acquire assets at a low cost with the hope of an increased return. As an investment strategy, this also serves the secondary purpose of steering clear of assets with an inflated valuation that may correct to their true value in the future.
If you’ve already been doing some research into the matter, you’d know that ‘undervalued assets’ is a term which crops up quite often in investment discussions. Here, we delve deeper into what it means and how you can capitalise on these types of assets.
Asset Undervaluation Meaning
The financial term ‘undervalued asset’ can be broadly defined as an asset (including real estate, stocks and bonds) that is currently priced below market value.
These assets could be undervalued for many reasons. For example, a real estate developer has run out of funds, cannot complete a project, and has pressing debts. In this scenario, the development could be available at a price below market value, and therefore an opportunity for investment.
You may also hear assets referred to as being ‘distressed’. Similar to the asset undervaluation meaning, these are assets that have been significantly devalued due to unique or unfortunate circumstances.
Being able to purchase such assets for less than their intrinsic value means seizing an opportunity to realise the full value of the investment, therefore making a profit.
Here, Seventy Ninth Group chairman, Dave Webster, talks about the way this works in the current economic climate, and the opportunity for investors:
Determining Value: Overvalued And Undervalued Assets
While ultimately the value of assets, and in turn the verdict on whether they are overvalued or undervalued assets is all subjective, there are certain factors to consider when evaluating an investment.
Looking at the financial statements of a company, investors can analyse key aspects like capital management, cash flow, profit generation and returns to get an idea of how much an asset is realistically worth.
For instance, if you’re investing in real estate, the undervaluation meaning can span having a property with a profit potential in a popular neighbourhood currently underappreciated by the property market. Other factors that would come into play to determine whether certain properties are overvalued or undervalued assets include comparative sales prices to similar buildings in the area.
Real estate undervalued assets might often be ‘fixer-uppers’, meaning they’re listed at a lower price because they need major renovations, but repair costs are something an asset management company will take into account when calculating the value of the investment.
Another difference between overvalued and undervalued assets in real estate comes from the rental income potential of a property. If that potential is high compared to the upfront cost of purchasing the property, it will be considered an undervalued asset. This will be further boosted if there is high demand for rentals in the area or if there are plans for future development that would increase the value of the investment.
Identifying Undervalued Assets
Being able to identify an undervalued asset takes in-depth knowledge of market dynamics. Asset management specialists will look at a series of metrics, including:
- Financial health – As mentioned above, the first step of the analysis covers evaluating the cash flow, revenue growth, earnings, and debt levels of a business.
- Discounted cash flow – Unlike cash flow, which outlines how much money goes in and out of a business over a set time period, discounted cash flow is an estimated future cash flow investors use to calculate how much an investment would be worth in the future.
- Comparative Price-to-Earnings (P/E) ratio – asset management experts also consider how the P/E ratio of a company compares to other organisations in the same industry. This provides useful context and can highlight whether the earning potential of a business is being underestimated by the market.
Investors also look at the broader picture painted by a combination of financial and non-financial metrics. This will include things such as brand strength, market position and the potential for growth.
By going beyond the limitations of simply looking at earnings, asset managers can identify investments which are undervalued due to external factors, like market sentiment.
What Makes An Undervalued Asset?
For an asset to be considered undervalued, rather than one not worth investing in, its poor market performance needs to be tied to external factors. These can include things like insufficient market attention (where a smaller business lacks brand awareness) and short-term financial challenges (an entire industry facing a temporary setback).
Bigger-picture elements can also come into play. From global recession to political turmoil and more general uncertainty, events unrelated to the intrinsic value of a company might cause its market value to drop.
Risks of Investing In Undervalued Assets
As mentioned earlier, subjectivity plays an inherent role in identifying undervalued assets. Individual investors, asset managers, and financial professionals use their expertise and experience to make the best judgement on when an asset is undervalued, and to what degree. It’s important to do your own research and understand there are always risks.
There’s always the possibility that the investment is actually a ‘value trap’, meaning it’s undervalued for a reason (e.g. lack of competitive power, poor management, or unfavourable growth prospects) and will further decrease in value over time.
This is why expert investors will always perform in-depth research prior to investing in undervalued assets, and many opportunities are only available to sophisticated investors.
Interested in learning more? Read our series of guides here or reach out to our team.
