Value Investors: How to Spot an Overvalued Stock
"Price is what you pay; value is what you get." - Warren Buffett
Overvalued Stock, Definition
First, it’s important to understand what it means for a stock to be overvalued. Generally, a stock is considered to be overvalued when its price isn’t justified by its earnings outlook. In other words, the stock trades at a price that’s above its fair market or intrinsic value. So if a stock’s intrinsic value is $10 per share but it trades at $20 per share, it would fit the definition of being overvalued.
There are different reasons why a stock may become overvalued. For example, the stock’s price may hold steady or increase even as the company’s underlying fundamentals taper off. When investor confidence is on the rise, pushing up demand for a particular company’s products or services, that can also result in an overvalued stock. And a stock could also be considered overvalued if prices continue to rise, despite earnings falling short of predicted growth estimates.
An overvalued stock is the opposite of an undervalued stock. When a stock is undervalued, it trades at a share price that’s below what the stock is actually worth. This type of stock is typically most appealing to value investors who rely on a buy-and-hold strategy.
How to Spot an Overvalued Stock If you’re on the hunt for stocks that are overvalued, studying certain ratios can help point you in the right direction. These ratios can be the most useful when gauging whether a stock is overvalued or undervalued.
Price-to-earnings (P/E) ratio. Price-to-earnings ratio measures a stock’s current share price relative to its earnings per share. Earnings per share means the net profit of the company divided by the number of outstanding shares of common stock. A high price-to-earnings ratio could be a sign that a stock is overvalued.
Price-to-earnings-growth (PEG) ratio. Price-to-earnings growth is a company’s P/E ratio, divided by its earnings growth rate measured over a set time period. A higher PEG can signify an overvalued stock, while a lower PEG can mean a stock is undervalued.
Price-to-dividend ratio. If the stock in question pays dividends to investors, you might also consider the price-to-dividend ratio to determine value. This ratio measures how much an investor has to pay to receive $1 in dividends. Dividends represent a percentage of a company’s earnings but not every stock offers them.
Price-to-sales ratio (P/S). The price-to-sales ratio can be used when a stock’s P/E ratio can’t be measured. This ratio represents the current stock price divided by the sales per share. The higher the ratio, the more likely it may be that a stock is overvalued.
Other factors and trends can help you spot an overvalued stock as well. For example, look at the current demand for the stock and what’s driving it. If there’s a sudden surge in buying activity, the result could be a rising per-share price that may not have happened otherwise. That could lead to stock prices becoming inflated.
On the flip side, look at selling activity. If high-profile investors are selling their shares in the company, that may indicate that the stock is overvalued. The same goes for insider trading, which the SEC keeps public track of. On the other hand, if investors are sitting tight that could mean they’re more confident in the stock’s value and its potential for continued price appreciation.
Going back to a company’s fundamentals can give you insight into what’s driving value and whether the stock is priced fairly in relation to earnings and demand. Earnings reports can be useful when analyzing short-term trends and forecasting a company’s potential for long-term growth.
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