Investor Guide: Identifying Undervalued Stocks in the PSX

Ever wondered why some stocks on the stock market seem to lag while others surge ahead? The answer often lies in valuation: a powerful lens that helps investors determine whether a stock is trading below, above, or at its true worth. Understanding valuation isn’t just for analysts or fund managers; it’s a foundational skill for anyone looking to make informed, confident investment decisions

Valuation is where numbers meet narrative. It’s about decoding the financial signals behind a company’s market price: its earnings, dividends, assets, and growth potential, and asking: Is this stock a bargain or a trap? For beginners, learning how to identify undervalued stocks means learning to spot opportunities where others see noise.

What Is Stock Valuation?

Stock valuation is the process of estimating a company’s intrinsic value: its true worth, based on concrete financial evidence. It helps investors judge whether a stock is undervalued (trading below its actual worth), fairly priced, or overvalued (trading above what its fundamentals justify).

Key Concepts:

• Intrinsic Value: The underlying worth of a business, derived from its assets, earnings, cash flows, and future potential. It’s independent of the current market price.
• Market Price: The amount buyers and sellers are willing to pay for the stock right now. This can swing with emotion, media buzz, or short-term trends.
• Valuation Models: These act as bridges between perception and reality. They use financial data to estimate what a company should be worth, and then compare that to its actual trading price.

When a stock’s intrinsic value is significantly higher than its market price, it’s considered undervalued. For investors, that’s a signal: the market hasn’t caught on yet, and there may be room for upside.

Why Does Stock Valuation Matter?

Valuation is how investors cut through the noise. It replaces guesswork with grounded analysis, helping you decide whether to buy, sell, or hold a stock based on real value, not hype.

It protects you from overpaying for trendy stocks and helps uncover hidden gems the market might be ignoring. By spotting gaps between price and worth, you apply the same disciplined logic that drives long-term value investing.

Valuation also strengthens your portfolio. It guides smarter allocation, favoring undervalued sectors and trimming overpriced ones, and keeps your focus on long-term business fundamentals, not short-term market swings.

Absolute vs. Relative Valuation: Two Ways to Measure Worth

Before diving into formulas, it helps to know that valuation models fall into two main categories: absolute and relative.

Absolute Valuation

This approach looks at a company on its own: its earnings, cash flows, and dividends, without comparing it to others. Common models: Discounted Cash Flow (DCF), Dividend Discount Model (DDM)

Relative Valuation

This method compares a company to its peers using financial ratios like P/E or P/B to see if it’s trading higher or lower than the industry average. Common models: Price-to-Earnings (P/E), Price-to-Book (P/B), EV/EBITDA

Smart investors often use both approaches together to get a clearer, more balanced view of a stock’s true value.

Dividend Discount Model (DDM)

The DDM values a company by treating dividends as the cash flows that go to shareholders. For companies with steady, predictable dividend payments, the simplest form (the Gordon Growth model) estimates next year’s dividend and divides it by (required return − growth) to give a long-run fair price.

When to use: mature companies with steady dividends

Example :

Given

• Most recent dividend D0 = $1.00
• Dividend growth g = 5% (0.05)
• Required return r = 10% (0.10)

Step 1: next year’s dividend (D1):
D1 = D0 × (1 + g) = 1.00 × 1.05 = 1.05

Step 2: fair price (Gordon Growth):
P0 = D1 / (r − g) = 1.05 / (0.10 − 0.05) = 1.05 / 0.05 = 21.00

5-year dividend snapshot:

Interpretation:

The DDM gives a fair value of $21.00 per share. If the stock currently trades at $18.00, the model suggests the stock is undervalued.

This method is quick and intuitive for stable dividend payers, but remember it is highly sensitive to the growth rate (g) and the required return (r).

Discounted Cash Flow (DCF)

The DCF values a company by forecasting the free cash flows the business will generate for owners and discounting those cash flows back to today using a chosen discount rate. It works for companies that do not pay dividends, but it depends on reasonable cash-flow forecasts and a sensible discount rate; a terminal value is typically used to capture value beyond the explicit forecast years.

When to use companies with reasonably predictable free cash flows

Example

Given

• Forecasted free cash flows: Year 1 = $50, Year 2 = $60, Year 3 = $70
• Discount rate r = 10% (0.10)
• Long-term growth after year 3 g = 3% (0.03)
• Shares outstanding = 100

Step 1: present value (PV) of forecasted FCFs
PV Year 1 = 50 / (1 + r)^1 = 50 / 1.10 = 45.45
PV Year 2 = 60 / (1 + r)^2 = 60 / 1.21 = 49.59
PV Year 3 = 70 / (1 + r)^3 = 70 / 1.331 = 52.59
Sum PV of forecasted FCFs = 45.45 + 49.59 + 52.59 = 147.63

Step 2: terminal value at the end of year 3
Terminal = (FCF3 × (1 + g)) / (r − g) = (70 × 1.03) / (0.10 − 0.03) = 72.10 / 0.07 = 1,030.00
PV(terminal) = 1,030.00 / (1 + r)^3 = 1,030.00 / 1.331 = 773.85

Step 3: total value and per-share price
Total PV = PV of forecasted FCFs + PV(terminal) = 147.63 + 773.85 = 921.48
Per-share value = Total PV / shares = 921.48 / 100 = 9.21

DCF table:

Interpretation:

The DCF gives a fair value of about $9.21 per share. If the market price is $8.00, the stock looks undervalued.

Note that the terminal value drives most of the total here, so the result is sensitive to the assumptions for long-term growth (g) and the discount rate (r).

Choosing between DDM and DCF

• Use DDM when the company pays stable, predictable dividends (fast and direct).
• Use DCF when dividends are absent or irregular, but you can forecast free cash flows.
• If both look appropriate, run both models, compare results, and always perform a sensitivity check (change r and g a little to see how the value moves).

Relative valuation

Think of relative valuation like shopping with a price tag: instead of guessing the exact future cash a company will make, you look at what the market is paying for similar companies today. It answers simple questions like: Are investors paying more for Company X’s earnings than they pay for Company Y’s? or Is this stock expensive compared with its peers?

Relative methods are fast, practical, and grounded in the market; they don’t replace deeper models (like DCF or DDM), but they give you a quick reality check. For a beginner, this is hugely useful: you can compare two companies in minutes and spot obvious bargains or overpriced stocks before you dive deeper.

Two common multiples

• P/E (Price-to-Earnings): P/E = Price / EPS. It shows how much investors pay for one dollar of the company’s earnings. A higher P/E often means investors expect faster growth.
• P/B (Price-to-Book): P/B = Price / Book value per share (BVPS). It shows how the market values the company’s accounting assets. A lower P/B can suggest the stock is cheap relative to its assets, but it can also reflect weak asset quality or low returns on equity.

We can explain this by using two companies as an example:

Given: Company A

• Share price = $20
• Earnings per share (EPS) = $2.00
• Book value per share (BVPS) = $5.00

Given: Company B

• Share price = $30
• Earnings per share (EPS) = $3.00
• Book value per share (BVPS) = $15.00

Compute ratios

Company A

• P/E = Price / EPS = 20 / 2.00 = 10.0
• P/B = Price / BVPS = 20 / 5.00 = 4.0

Company B

• P/E = Price / EPS = 30 / 3.00 = 10.0
• P/B = Price / BVPS = 30 / 15.00 = 2.0

Comparison Table

Interpretation:

Both companies have the same P/E (10.0), so the market is paying the same amount for each dollar of earnings. But Company A’s P/B is 4.0 while Company B’s P/B is 2.0. That suggests investors value Company B’s accounting assets less (or Company B has more assets per share).

In simple terms, by earnings, they look equally priced; by book value, Company B is cheaper. This could mean Company B is an asset-light business with higher intangible value, or it could mean its assets are less valuable; so you’d check profitability (ROE), growth prospects, and industry differences next.

Checklist:

• Always compare companies in the same industry.
• Look at growth and profitability (EPS growth, margins, ROE) to explain P/E differences.
• Watch for accounting quirks (one-off profits, write-downs) that can distort P/E or P/B.
• Use relative valuation as a first filter, then validate with DCF or deeper analysis.

Investor Guide: Identifying Undervalued Stocks in the PSX

Key Valuation Ratios: Two simple metrics often used to spot bargains are the Price-to-Earnings (P/E) ratio and the Price-to-Book (P/B) ratio. A low P/E (stock price divided by earnings per share) suggests the market is paying less for each unit of current earnings. Likewise, a P/B below 1 means the stock is trading below its book value (net assets per share). These “relative” measures should be compared to peers or historical averages; significantly lower values can signal a potentially undervalued stock.

Banking Value: UBL & ABL

United Bank Limited (UBL) snapshot

Price ≈ PKR 370

EPS ≈ PKR 65.8

P/E ≈ 4.95

What it suggests

Simply put, investors are paying about 5 times UBL’s annual earnings. That’s low for a large bank and suggests the market is valuing UBL conservatively; it could be a bargain if earnings remain steady. Use this as a starting flag: check recent profitability trends, loan quality, and any one-off items before concluding it’s truly undervalued.

Allied Bank Limited (ABL) snapshot

Price ≈ PKR 182

EPS ≈ PKR 37.7

P/E ≈ 6.27

What it suggests

Investors are paying about 6 times ABL’s annual earnings. This single-digit P/E also points to relative cheapness versus peers and is worth further review. As with UBL, investigate earnings sustainability, asset health, and dividend policy to confirm whether the stock is genuinely undervalued.

Takeaway

Both UBL and ABL show single-digit P/E ratios; a useful signal for value-oriented investors to dig deeper: the numbers hint at possible bargains, but follow up with checks on earnings quality, loan performance, and future growth prospects.

Evaluating Stocks Using DDM and DCF Models

Once we’ve explored the basic valuation ratios, the next step for investors who want a deeper understanding is to use intrinsic valuation models. Two of the most reliable methods for this are the Dividend Discount Model (DDM) and the Discounted Cash Flow (DCF) model. These methods go beyond surface-level metrics and focus on the true earnings and cash-generating potential of a company.

1. DDM Example: Kot Addu Power Company (KAPCO)

The Dividend Discount Model (DDM) is best suited for companies that pay stable and predictable dividends, like those in the power sector.

Let’s take Kot Addu Power Company (KAPCO) as an example. The company’s share price is around Rs 29.35, and it pays an annual dividend of about Rs 7.00 per share. Because KAPCO’s dividend pattern has remained quite steady over the years, we can assume a zero-growth rate in dividends for simplicity.

If investors require a 15% return (reflecting the typical market risk), the DDM formula is:

Value = Dividend per share ÷ (Required rate of return – Dividend growth rate)

Putting in the numbers:

Value = 7 ÷ (0.15 – 0)
Value = Rs. 46.7 per share

This gives a fair value of roughly Rs 46.7, which is much higher than its current price of Rs 29. This suggests that KAPCO may be undervalued, especially considering its strong dividend yield. Even if we adjust the required return slightly higher (say to 18–20%), the stock still appears attractive for income-seeking investors.

2. DCF Example: Atlas Honda Limited (AHL)

The Discounted Cash Flow (DCF) model helps investors estimate the real worth of a business by calculating the present value of all the cash it is expected to generate in the future. For a well-established manufacturer like Atlas Honda Limited, this model captures how its consistent profitability and reinvestment translate into long-term value.

Using the company’s 2025 data:
• Free Cash Flow (FCF): Rs 25,299,992 thousand
• Discount Rate (WACC): 26.48%
• Shares Outstanding: 124,087,935
• PAT Growth (2020–2025): ≈ 34% CAGR*
(Calculated as [(15,251,615 / 3,078,400)^(1/5)] – 1 = 0.34 or 34%)

Assuming free cash flows grow at 10% annually for the next five years and then 4% in the long run, discounted at 26.48%, the total firm value is estimated at around Rs 143 billion. Dividing this by 124 million shares gives an intrinsic value of roughly Rs 1,153 per share.

With Atlas Honda’s current PSX market price near Rs 1,454.7, the stock appears slightly overvalued relative to its intrinsic worth. This example shows how DCF analysis helps investors focus on a company’s true earning power rather than short-term price swings.

Conclusion

Both DDM and DCF models give investors a clearer picture of a stock’s true worth. While the DDM is ideal for steady dividend payers like utilities and power companies, the DCF is better suited for growth-oriented or diversified firms. Together, they form a solid foundation for identifying undervalued opportunities in the PSX.

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