Finding a stock that is trading below its equity value is something the major and minor brokers are always looking for. Of course, that stock must also have the potential for growth. Sometimes, trading below equity is a very good thing for traders -- they may have discovered a potentially powerful unknown firm. It can also be bad -- they may have discovered a firm in terminal decline. Either way, shares trading below equity get the attention of traders and brokers.
The concept of “equity value” is a common one in stock market investing. Equity value is computed by taking the cash flows predicted over a period of time and subtracting all liabilities of the firm. Equity value, therefore, is an important indicator for market investors because it is an accurate picture of the amount of cash the firm is actually seeing on a regular basis relative to its debts. There must be very special circumstances for stock to be trading below this value.
Trading Below Par
A stock trading below its equity value is an important find for most investors, especially if that firm is undervalued for specific reasons. In general, new firms like to undervalue their initial public offerings because it will attract investors. A new firm is generally an unknown firm, therefore, the IPO must be fairly cheap. This does not in any way reflect the health of the firm, but the low IPO price under most conditions is about attracting positive attention. Even more, a firm might want to undervalue its stock at any time in its development if it wants a quick sale. This is the case, for example, when a firm wants fast cash to pay off short-term debt.
When market volume falls and the economy seems unstable or rapidly shrinking, some stocks will trade below equity. In theory, this price, too, will have no real reflection on the health of the firm, but rather the health of the market. Equity values are very different from market values. A market value of a firm might dip way below what the firm is worth -- the equity value -- if the markets themselves are seeing money leave and go into commodities or bonds. Therefore, if interest rates are expected to rise, and rise drastically, money will leave the markets. This can lead to many firms trading under equity.
While market values often have no relation to the fundamentals of the firms involved, the reverse can also be true. The firm might be poorly managed, have labor troubles or is involved in a costly lawsuit. In this case, a firm that otherwise could be valuable is dipping below that potential. Therefore, once this information becomes public and well-known, it is very possible that the stock itself might be undervalued. In this case, the undervaluing has much to do with the condition of the firm.
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