An oversold stock is one that trades at a price that is lower than its perceived intrinsic value. By definition, an oversold stock is one that analysts believe has the potential to rise in price.
Just because a stock meets the criteria for being oversold does not necessarily mean it’s ready to over-perform. Rather it is a way for analysts to define the current state of supply and demand. Analysts seek to find the sweet spot between price (which is the dollar amount investors pay for a security) and value (what that security is actually worth).
In this article, we go deeper into the reasons a stock becomes oversold and the technical indicators that investors look at to identify oversold stocks. It also touches on the importance of conducting fundamental analysis that may confirm the technical trend for a stock.
What Is Intrinsic Value?
The most basic definition of intrinsic value is as an estimation of what a business is worth if the entire business and its assets were sold off. Intrinsic value is a measurement of a company’s financial performance based on its cash flow.
Intrinsic value is different from the current stock price. Analysts use objective calculations or proprietary financial models. A common model used to calculate intrinsic value is the discounted cash flow formula.
To use the discounted cash flow formula, investors must know three data points:
- The company’s estimated future cash flows
- The discount rate (this is used to determine the present value of estimated future cash flows)
- A terminal value (a method for valuing the company at the end of the cash flow estimate)
This can look intimidating for many investors who don’t have a finance background. However, many stock analysts will provide intrinsic values for a company.
What are the Limitations to Intrinsic Value?
The primary limitation to calculating intrinsic value is that not every asset has an intrinsic value. For example commodities, such as gold and silver, don’t generate income so by cash flow models, they have no intrinsic value. The same is true of cryptocurrencies.
Another limitation to intrinsic value occurs with companies that have limited revenue or profits. These companies have an intrinsic value, but there is a lack of confidence in estimates of future revenue and profits. That same lack of confidence will be a concern when calculating intrinsic value.
What Can Cause a Stock to Become Oversold?
Investors will look at both fundamental and technical indicators to identify an oversold stock. Fundamental analysts will look at metrics such as a company’s price-to-earnings (P/E) ratio in comparison to other companies within that sector or industry. They will also look at earnings reports that help describe the inner workings of a company including a review of their balance sheet for capital flows and debt levels.
Negative News Events – This can include items such as a product recall or a lawsuit. For a biotech company, it can mean failing in a clinical trial.
Negative Economic Reports – Every month, investors get a series of economic reports that provide directional clues to the health of the overall economy. These include retail sales data, information on housing starts, the consumer price index (CPI) and the producer price index (PCI) which provide data on inflation, and the monthly jobs report.
Geopolitical Events - Wars, trade disputes, and issues such as financial sanctions or embargos can have an effect on individual stocks and/or entire sectors.
Earnings Reports – While these can technically be considered news events, earnings reports are generally seen as an event unto themselves. Companies go to great lengths to prepare analysts and investors for bad news, but are not always successful.
Change in Management – This can be bullish if a leader who is perceived to be ineffective is being replace. But if an effective leader is being replaced, it can cause investors to sell in expectation that the new leader will not be as effective in managing the company.
Should Investors Use the Price-to-Earnings (P/E) Ratio in Determining an Oversold Stock?
A company’s price-to-earnings (P/E) ratio is a measure of how much it costs an investor to buy one dollar of a company’s profits. So a P/E of 25 means it will cost an investor $25 to buy one dollar of a company’s profits.
In general, a lower P/E number means a stock could be oversold. However, investors should be less concerned about a company’s individual number and more concerned about how its number compares to other companies in its sector. They may also look at it compared to a benchmark index or with companies that have a similar market capitalization (market cap). A stock that is trading significantly lower than others in its sector may indicate that the stock is oversold.
What is the Relative Strength Indicator (RSI)?
However, fundamental indicators, only get investors so far. Technical analysts will look at technical indicators that will help them confirm an oversold condition. One of the most common of these is the Relative Strength Indicator (RSI).
The RSI is a technical indicator that measures volatility. RSI is expressed as a ratio of the average upward movement to the average downward movement of a stock over a specific period of time, typically 14 days. The RSI attempts to reveal how committed buyers and sellers are to their positions.
Like any index, the Relative Strength Index is only as good as its benchmarks. In this case, investors typically pay attention to the numbers 30 and 70. An RSI below 30 is seen as an oversold indicator. When a stock is in a downtrend, sellers will outnumber buyers meaning the index will show more lows than highs.
Traders use charting software to overlay the RSI, along with other technical indicators, on a daily chart. Here are some additional technical indicators that traders use with the RSI to identify oversold stocks:
Candlestick Patterns – Displaying a daily chart using a candlestick pattern tells traders a story of price movement by both the shape and shading of the candle. Because they are useful in identifying potential changes in market direction, accurate interpretation of a candlestick pattern can provide confirmation for an RSI level.
Bollinger Bands – these are bands that are plotted one standard deviation above and one standard deviation below a security’s exponential moving average. A security that is selling near the low end of the lower Bollinger band and has a low RSI is usually considered oversold.
Fibonacci Retracement Levels – A Fibonacci retracement level is identified by taking an extreme high and low on a stock chart and dividing the distance between the two (visually this will be the vertical distance) by the key Fibonacci ratios (23.6%, 38.2%, 50%, 61.8%, and 100%). These levels will then be defined on a chart by horizontal lines that indicate potential areas of support and resistance. It is unclear why the Fibonacci ratios are such a consistent predictor of stock price movement only that they are.
Moving Average Convergence/Divergence Oscillator (MACD) – The moving average convergence/ divergence oscillator shows the relationship between two exponential moving averages (EMAs). The most common moving averages used are the 26-day moving average as the longer average and the 12-day moving average as the shorter average. By subtracting the longer average from the shorter average, the MACD displays both the trend of the price action for the underlying security as well as the momentum of buying and selling activity. The companion to the MACD line is a signal line which is the 9-day EMA for the asset being used. The MACD is a momentum oscillator that moves above or below a center line (also called a zero line). Traders will look for signal line crossovers, center line crossovers, and divergences between the MACD line as triggers for buying (bullish divergence) and selling (bearish divergence).
What Are the Limitations to Using Technical Indicators to Find Oversold Stocks?
- A turnaround may not be immediate – Stocks don’t move in the same direction all the time, but when a stock becomes oversold, it can stay that way for a long time. That may not be an obstacle for a long-term investor, but traders will want to use other indicators to confirm a reversal is imminent.
- Investor sentiment is an imperfect metric – To put it simply, investors aren’t always rational. That means that a fundamentally sound company may see its stock continue to fall in price due to the “madness of crowds” effect.
- The definition of an oversold stock is subjective – Technical indicators offer one data point, but analysts may disagree on what it’s actually saying about the fortunes of a stock.
- Sometimes a stock is oversold for a reason – Technical indicators can show you the what, but not the why. It’s important for investors to perform their own due diligence to ensure they are not trying to catch a falling knife.
Some Final Thoughts on Finding Oversold Stocks
When a stock is oversold, analysts mean that its price has gone too far in a negative direction. They base this on both fundamental and technical indicators that suggest that the stock is now trading at a discount to its intrinsic value. When confirmed with other trading signals, an oversold stock can be a buying signal.
To determine an oversold condition, investors will use both fundamental and technical analysis. Some fundamental metrics that will be used include the price-to-earnings (P/E) ratio, earnings reports and a company’s balance sheet. This may be sufficient for long-term investors.
On the other hand, traders, particularly day traders, will look at technical indicators to help them define their trading strategies. One of the most common indicators is the Relative Strength Index (RSI) which helps to show the momentum and volatility surrounding price movement. When the RSI is used with other technical indicators it can provide further confirmation of oversold conditions.
However, just because the RSI shows an oversold condition does not mean the stock is certain to rise in price. Stocks can rise and/or fall for reasons that defy market expectations.
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