8 Ways to Help You Spot an Overvalued Stock

By Chika

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Last Updated: January 20, 2023

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Sometimes stocks trade above their fair value. Sentiments, market volatility, high expectations of future earnings, or wrong valuations could make a stock trade for more than what it is worth.  

A stock provides a favorable investment opportunity when it trades for much less than its intrinsic value.

On the flip side, if sells above its intrinsic value, you can either avoid it or short it.

However, how can you tell if a company is overpriced or undervalued? Making multiple predictions about the direction of the company, the economy, and interest rates is necessary to come to this conclusion.

Fortunately, there are a few financial ratios that might be useful in identifying an expensive or inexpensive stock. In this post, we examine expensive stocks and discuss how to make predictions about their future price fluctuations.

 

 

What are overvalued stocks?

Stocks that trade for more than they are actually worth, or what is "fair," are said to be overvalued.

A company's financial collapse and sudden increases in buying, which are often motivated by emotion, can both lead to expensive stocks.

However, equities occasionally remain overpriced for longer than expected. The market may also be shorted by traders employing derivatives like CFD trading and spread betting when they look for expensive stocks.

 

 

Why do stocks become overvalued?

There are a variety of reasons why stocks become overvalued. Let's look at some of them. 

Surge in investor demand.

Trading volume measures how much market activity there was over a specific period and how many stocks were purchased and sold during that period.

A high demand for stocks could result in stock overvaluation. Sometimes trading volume on a stock may increase because there are people chasing prices. Other times it may be because of FOMO. 

Company earnings.

When the economy suffers like in a recession, public spending decreases, which causes the company earnings to drop.

This subsequently causes the company’s stock price to drop and adjust to the new earnings level.

Press coverage.

A stock can become overvalued if it receives a lot of press coverage.

If a stock receives significant media hype, this would increase investor interest in the stock, which leads to a lot of people buying the stock and chasing prices. This is the situation with a lot of blockbuster IPOs in 2020 like DoorDash and Airbnb.

Cyclical fluctuations.

Economic cycles can also prop up the price of a stock above its intrinsic value.

During every economic cycle, some companies perform better than others. For example, in a recession, defensive stocks do better. However, because investors are taking up positions in these stocks, there is a tendency for them to be overbought which makes their prices go higher than their fair value. 

 

 

Six ways to spot an overvalued stock

There are financial ratios you can use to determine a stock's fair value used by traders. Let's look at some of them. 

#1. Price-earnings ratio (P/E)

The price-to-earnings ratio (P/E) is one metric used to determine a company's stock value.

In essence, it describes how much money you'd need to spend to generate $1 in profit. An elevated P/E ratio may indicate that the equities are overpriced. As a result, it could be helpful to examine the P/E ratios of rival firms to determine whether the stocks you want to trade are overvalued.

By dividing the market value per share by the earnings per share, the P/E ratio is calculated (EPS). The company's overall earnings are divided by the number of shares it has issued to arrive at the EPS.

For example, let's say you purchase a company's shares sat at $100 each. With five million shares in circulation, the company makes a $2 million profit. This means that the P/E ratio is 250 ($100 divided by 40c). As a result, for every $250 you spend on the stock, you make $1 in profit.

 

#2. Price-earnings to growth ratio (PEG)

The price-earnings-to-growth ratio examines the P/E ratio in comparison to the rate of yearly earnings growth.

A company's stock may be overpriced if its per share is below average and its price-earnings-to-growth ratio is high. A PEG ratio above 1.0 suggests a stock is overvalued.

For example, if a company's share price is $100, and it pays $5 earnings per share, its earnings rate is 5% ($5/$100), and the P/E ratio is 20 ($100/$5). Thus its PEG ratio would be 4 (20/5%).

 

#3. Relative dividend yield

Dividend yield measures the relationship between a company's yearly dividends—the fraction of profit distributed to shareholders—and its stock price.

The dividend yield of a single company as opposed to the entire index, such as the S&P 500, is known as the relative dividend yield.

To calculate the relative dividend yield, first, you calculate the dividend yield for the stock.

  • This is obtained by dividing the annual dividend of the stock by its current share price.
  • Next, you divide the company’s dividend yield by the average dividend yield for the index. 

When a stock has a low dividend yield, this means that it is overvalued. 

For example, a company's share trades at $100 and pays out dividends of $2 per share every year. The current share price is $100, which means the company’s dividend yield is 2% ($2/$100). The average for the index is 4%, which means the relative dividend yield is 0.5 (2%/4%).

 

#4. Debt-equity ratio (D/E)

The D/E ratio compares the debt of an organization to its assets.

It is calculated by dividing liabilities by stockholder equity. A lower ratio may indicate that the majority of the company's funding comes from its shareholders.

Even yet, this does not indicate that the stock is overpriced. You should always compare a company to its peers when utilizing the D/E ratio to see whether it is trading at fair value. This is such that a "good" or "poor" D/E ratio might vary depending on the sector.

If a firm has $1 billion in shareholder ownership and $500 million in debt (liabilities). The D/E ratio ($500 million/$1 billion) would be 0.5. This indicates that for every $1 of equity, there is $0.50 in debt.

 

#5. Return on equity (ROE)

ROE measures a company’s profitability against its equity expressed as a percentage.

ROE is calculated by dividing net income by shareholder equity. A low ROE could be a sign that the shares are overvalued, because it indicates that the company isn't generating enough income relative to the amount of shareholder investment. 

Yet, it could also mean that the company is reinvesting income and dividends. This is especially true if the company is a growth company. However, if it is a mature and more established company, a low ROE could be an indication of overvaluation. 

For example, let's say a company has a net income (income minus liabilities) of $100 million and a shareholder equity of $120 million. This puts its ROE at 83% ($100 million/$ 120 million).

 

#6. Earnings yield

The earnings yield is the opposite of the P/E ratio.

It is calculated by dividing earnings per share (EPS) by the price per share, instead of price per share by earnings. Some investors assume that if the yields on the 10-year Treasury note are higher than the earnings yield, then the stock is overvalued. 

Let's say a company's stock trades at $50 per share and its earnings at $10 per share. This simply means that the stock's earning yield is 20%.

 

 

Final Thoughts

When you own stock in a great business, the stock's value is likely to grow over time.

It's often a mistake to part with a stock just because it might have gotten a bit pricey. Sometimes investors are betting on future earnings which may later turn out to be true.

Look at Amazon for example. If you had traded the stock based on overvaluation metrics when the company went public, you would have missed out on a lot of money. As such, you have to balance the use of financial ratios with other factors such as industry trends, macroeconomy, market share, etc. 

Albeit, it is always good to confirm if a stock is overvalued or not. 

Photo by Brett Jordan

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