How to Know if a Stock is Overvalued
When a stock is trading at a low price to its intrinsic worth, it represents a compelling buying opportunity. However, when a stock’s price rises beyond its intrinsic value, it’s time to either cash out or look elsewhere for investing opportunities.
But how to know if a stock is overvalued? Some easy-to-understand ratios and indicators help determine if a stock is reasonably priced or overvalued. Thoroughly studying and analyzing the economy and a company’s operations is also required to obtain an accurate valuation.
- An overvalued stock is one that’s trading higher than its fair market price.
- Rising demand, cyclical fluctuations, news, events, and company reputations can all contribute to stock prices being higher than a company’s value.
- To know if a stock is overvalued, calculate valuation multiples such as the price-to-earnings ratio.
- Observe the actions of corporate insiders with regard to their stock holdings. This is another reliable indicator of whether or not a company is overpriced.
- Review turning points in the economic cycle to determine if a company is overvalued due to consumers buying more goods or services than normal.
What is an overvalued stock?
Stocks are considered to be overvalued when they are traded higher than their fair market or selling price. In other words, the price is significantly higher than a stock’s intrinsic value (a stock’s intrinsic value is its estimated worth).
As determined by the price-to-earnings ratio, an overpriced company trades at a premium to its future profit potential. Overvaluation occurs when a company’s stock price sells much higher than its competitors.
Related: How to Find Undervalued Stocks
Real-world example of an overvalued stock
Netflix, the video streaming service accessed all over the globe, is a company whose stock is likely overpriced.
The company’s share price began at $120 when it was launched, but it’s climbed to over $200 at its all-time high. As of September 2022, the intrinsic value of Netflix was $201.02 USD. Compared to the current market price of $240, Netflix is overvalued by 16%.
What factors contribute to a stock price becoming too high?
Rising demand and cyclical fluctuations
Investor interest in a company’s shares can surge unexpectedly – maybe consumers suddenly begin buying more of a company’s product. As trade volume increases, it’s possible that prices may climb beyond their intrinsic value.
Also, some businesses thrive more than others during prosperous economic periods. Cyclical companies sell more goods and services, such as furniture and airline tickets, when the economy is doing well.
But this can significantly increase the price of the stock, even though the value of the company stays the same. If the economy suddenly tanks and consumers cut extra spending, company stock prices can decrease and highlight overvalued companies.
News and events
Short-term stock price fluctuations and overvaluations can be caused by news and events such as elections, political instability, or military interventions.
This was evident in 2020 when coronavirus was at its peak. For example, the e-commerce platform Shopify performed well during the pandemic. During lockdowns, consumers flocked to online shopping, giving the company a pandemic-driven bump in sales. According to Alpha Spread, the intrinsic value of one SHOP stock is $21. Compared to the current market price of $33.94 (as of September 2022), Shopify is overvalued by 38%.
An organization’s good name may significantly affect the value of its stocks. Overvaluation of a stock might occur if well-known investors have recently bought it. People may also become more interested in purchasing a company’s shares if there has been an unexpected spike in positive publicity. Stocks may be overvalued as a result.
How to know if a stock is overvalued in three steps
Investors can evaluate whether a stock is overpriced by comparing its valuation to other firms, historical values, and industry averages. Below are a few methods to determine if a stock is overvalued.
1. Calculate valuation multiples
Valuation multiples compare one financial indicator to another to evaluate firms. Investors can understand how the industry values a firm by comparing its financial ratios to those of similar firms and the market as a whole. Overvaluation exists if the stock’s valuation multiple is higher than that of major rivals.
Price-To-Earnings (P/E) Ratio
Among the many ratios used in valuing a company, the price-to-earnings (P/E) ratio stands out as a popular metric. It looks at the stock price in relation to the company’s EPS. The earnings multiple offers a straightforward representation of the current stock price relative to the company’s earnings. Price-to-earnings ratio (or P/E ratio) is calculated by dividing the current share price by the company’s 12-month EPS.
Price To Earning = Current Share Price / Earnings Per Share
For example, if the price of a share is $75 and its EPS is $6, its price-to-earnings ratio would be calculated by dividing $75 by $6. That’s equivalent to a 12.5 P/E ratio. If a company’s stock trades at a much higher P/E than its rivals, it might indicate that the stock is overpriced.
Related: 7 Valuation Metrics to Use
Enterprise Value (EV) To EBIT Ratio
Both EV and EBIT are measures of financial performance; EV considers any potential financing debt, while EBIT determines profit before interest and taxes. For the EV/EBITDA ratio to be valid, a company must generate enough operating profits after accounting for expenses like depreciation and amortization.
Consider the following formulas when calculating Enterprise Value and EBITDA:
Enterprise Value (EV) = Equity Value + Net Debt
EBITDA = Earnings Before Tax & Interest + Depreciation + Amortization
Price-To-Sales (P/S) Ratio
The price-to-sales ratio (P/S) might be used as a substitute for earnings when a company lacks profitability or shows negative earnings but has revenues. The P/S ratio is determined by dividing the stock price by the company’s per-share sales.
Price To Sales Ratio = Market Price Per Share / Sales Value Per Share
Sales Value Per Share = Twelve Month Sales Of A Company / The Number Of Outstanding Shares
A low P/S ratio relative to competitors may indicate undervaluation, whereas a high P/S ratio would be indicative of overvaluation. Even when a company has reported negative profits, its valuation may be estimated using the P/S ratio.
Price-To-Earnings Growth (PEG) Ratio
A growth-adjusted version of the P/E ratio is known as the PEG ratio, which shows a more in-depth evaluation of P/E. This ratio provides vital information for analysts or investors in the financial sector. It offers investors a more comprehensive picture of a company’s profitability by considering its earnings growth.
There may be overvaluation in a firm’s shares if the PEG ratio is high yet earnings are low. The PEG ratio is helpful because it facilitates the comparison of stocks with different expected growth. Any stock with a PEG ratio higher than 2 is likely to be overpriced. A PEG ratio under one is sometimes seen as a sign that a company is underpriced. However, it’s not always the case, depending on the sector. Consider the following formula and example to understand the PEG ratio.
PEG ratio = P/E ratio / EPS growth
Compare two companies: say company A has a P/E of 15 and a growth rate of 9%; company B has a P/E of 35 and a growth rate of 30%. Using the PEG ratio, investors could evaluate the relative worth of each of these stocks. After calculating, Stock A has a PEG of 1.67, whereas Stock B has a PEG of 1.16. According to this analysis, B would be the undervalued stock compared to A stock.
2. Look for internal signs
Observing the actions of corporate insiders with regard to their stock holdings is another reliable indicator of whether or not a company is overpriced.
Executives and influential people often know their company very well. If they are offloading shares, it can indicate that they believe the stock already overvalues the company’s prospects for success.
Related: What is a Value Trap?
3. Consider turning points in the economic cycle
As mentioned, some businesses experience growth and decline in tandem with the economy, making them cyclical. These companies may be among the hardest to evaluate since, at times, they look undervalued compared to other companies using ratios like a price-to-earnings percentage.
They might look overpriced when earnings are low, and valuation multiples are high. Think about the economic process and the possibility of a downturn if you come across a cyclical firm selling at a low multiple.
Never base your investment decisions on just one or two indicators; remember that there is no silver bullet. Many factors, including valuation ratios, insider trading, and the current economic cycle, help you determine whether or not a firm is overpriced.
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