Every investor’s dream would be to find undervalued stocks and buy them at a low price to make substantial profits.

There are many ways to determine the intrinsic value of a stock, including discounting its cash flow or its dividends. That means that different people will conclude differently about a particular stock’s value and therefore draw different conclusions as to whether the stock is actually “undervalued”.

Learning from the renowned investor blogger AK, we will take a look at how he analysed Tuan Sing Holdings, a supposedly “undervalued” stock because it is trading at a huge discount to its net asset value (NAV). NAV measures the company’s assets minus its liabilities on a per-share basis.

Tuan Sing Holdings Limited is a listed company on the SGX that mainly deals with property development, property investment and hotel ownership.

With a NAV of $0.77 and current share price of $0.35, it’s trading at 54.5% discount. However, not all discounted stocks are bargain purchases.

Therefore, following are three things that investors should look out for before purchasing these seemingly “undervalued” stocks.

1. Identify the reason for the discount

As we all know, there’s no such thing as a free lunch. When something is too good to be true, it probably is.

There must be reasons that caused these stocks to be trading at a hefty discount to its NAV, and investors should identify them to ascertain if the discount is due to an overly pessimistic market that has actually undervalued the stock, or investors are shying away from this firm for a good reason.

In Tuan Sing Holding’s case, AK identified the reasons for its low stock price as the decline in earnings and a weak balance sheet with high gearing level and low-interest coverage ratio.

As he mentioned, “interest cover ratio has also weakened from 14x in 2012 to just 2.2x in 2016”. A low-interest cover ratio signifies that the company may find it difficult to cover its interest expense with its earnings.

A continued deterioration of this ratio should alarm investors as the firm may eventually default on interest and principal repayment.

Identifying why the stock is undervalued is important to determine if the problems are permanent.

In this case, if the balance sheet does not grow stronger, then this investment may be a risky one considering that the firm has a higher chance of defaulting on payment, and its operations may not be the most profitable one.

In the long run, if the business does face difficulties in remaining profitable then investors will obviously not benefit from an increase in share price regardless of the discount to NAV.

2. Getting paid while waiting for value to be unlocked

Upon further research, investors may conclude that there is indeed value to be unlocked from the firm due to the significant discount to NAV and a potential increase in recurring profit in the future.

Therefore, the investors who have a longer investing the horizon may want to invest and wait for the share price to eventually be properly valued and climb upwards.

Investors who have identified an “undervalued” stock which should increase in price in the long run, but not knowing how long it will take, should look at the dividend yield to consider if they will purchase the stock.

In Tuan Sing’s case, its dividend per share was 0.6 cents last year, which brings a 1.7% dividend yield based on current share price of $0.35.

In AK’s words “anyone who buys into Tuan Sing for [passive] income has to be mental”. He made that remark as he compared Tuan Sing to Guocoland, which provided a 2.7% dividend yield but in his opinion “was not an ideal investment for income either”.

3. How much to invest, and can we afford to invest?

AK concluded his post by saying that he only took a “nibble” at Tuan Sing. He invested just a small amount because he did not know how long it will take before Tuan Sing’s value in currently-developing properties will be unlocked.

It shows us that when we are uncertain about the waiting period, we should not be overly-invested to prevent ourselves from having cash flow issue, with money stuck in an investment that will take a substantially extended period before it pays off.

Furthermore, when investing in these undervalued stocks, AK mentioned in another post that we should be able to “afford patience”. We should not be investing with borrowed money.

Most importantly, we should never invest a substantially big amount that will cost us our peace of mind while anxiously waiting for the stock price to increase. Every investment carries risk (it’s just a matter of how much).

Hence, we should never be overly-invested beyond our comfort zone and end up stressing over the ups and downs of the stock market.

Therefore, the next time you hear your friend telling you about a “great deal” and it is “guaranteed to make money”, do think of these three points and make your own evaluation of the stock before jumping in!