Anybody who enters the stock market will undoubtedly encounter the name Warren Buffet. When they attempt to understand Mr. Buffet’s investment theory, they encounter terms like book value, undervalued stocks, overvalued equities, and value investing.
In this article, we will look at market overvaluation, why stocks become overpriced and some ways to identify them.
Also read: Value investing in India
What does overvalued or undervalued stocks mean?
Overvaluation means an asset is priced at more than its intrinsic value. Though there is no universal definition of intrinsic or fair value, analysts use various complex qualitative and quantitative analysis techniques to define intrinsic value. The most commonly used technique to find the fair value of a company is Discounted Cash Flow(DCF).
Though there are many methods used by investors, DCF is commonly used worldwide. In a nutshell, analysts estimate how much cash flow a company is expected to generate in the next few quarters or years, depending on those cash flows they estimate how much a company should be valued in the present.
Why do stocks become overvalued or undervalued?
The real value of a company often deviates from its intrinsic value due to many reasons. Firstly, because different institutions arrive at different conclusions about an asset’s inherent value, buying and selling among them can cause the price to rise or fall.
Secondly, the company’s most recent announcements and news encourage traders to purchase and sell their shares in different amounts in an effort to turn a profit quickly. That pushes the price of an asset above or below the fair value.
Market participants frequently overestimate or underestimate the news possible impact, which results in either an overvaluation or an undervaluation.
Third, when the share of a company starts rising, it attracts many market participants who buy the already overvalued share more in anticipation of a further price rise. This purchase increases the price, which validates their prior assumption and leads to further purchases. This becomes a loop that sometimes takes a share or sector way above its intrinsic value. Similarly, when a share price declines the opposite takes place.
Also read: Sustainable and Ethical Investing
Methods to identify overvalued stocks?
Here let us take a look at four most common ratios which are used to identify overvalued stocks.
- Price to Earnings ratio(P/E): Price to earnings ratio means the price of a stock divided by earnings per share of the past 12 months. A stock’s current P/E ratio is compared to its historic P/E or the particular stock’s P/E to the P/E of an index or sector.
If a stock shows a sudden spike in P/E ratio as compared to the past or compared to its peers then it might be deemed as overvalued.
For example, if a stock has a P/E ratio of 70 and the sector to which it belongs has a P/E ratio of 30, some investors may think the stock is overpriced.
- PEG ratio: Price to Earnings Growth (PEG) ratio is an extension of P/E ratio. This ratio is calculated by dividing the P/E ratio by the growth rate of earnings per share. Low PEG values are interpreted as undervaluation and vice-versa. The degree to which a PEG ratio value indicates an over or underpriced stock varies by industry and by company type.
For example a stock has a P/E ratio of 20 and its earning growth rate is 4% therefore its PEG ratio will be 5, but a similar company with similar earnings growth has a P/E ratio of 40, making its PEG ratio at 10. Hence, the other company can be considered overvalued.
- Price to book value: Book value here means value of shareholders equity per share, meaning total assets minus total liabilities. P/B ratio divides price of a share by book value of a share. The method of interpreting this ratio is the same as the P/E ratio by comparing current P/B with past P/B or comparing P/B of a stock with its peers or an index.
For example if a banking stock has a P/B ratio of 40 whereas all other banking stocks have a P/B of 3, it can be considered overvalued by some investors.
- Price to Sales ratio: This ratio is useful when comparing companies that have no earnings or if a company is incurring losses. Price per share is divided by revenue per share. This ratio compares the price or market value of a company to its sales.
For example, assume that two of the four businesses in a sector are profitable. The price-to-sales ratio for one losing company is 10, compared to five for the other three. Even though the company is losing money, its stock may be overpriced compared to its competitors.
Also read: Unlocking financial insights: The power of ratio analysis
Bottomline
These ratios are not a Holy Grail of finding stocks to buy or sell. There are many factors at play in stock markets. A company may be overvalued by these ratios but there can be a genuine reason for the same like a monopoly product, a patent, etc. Similarly, undervaluation does not mean you can buy right away.
After spotting an underpriced or overpriced stock, deep research must be conducted as to what are the reasons behind it being under or overpriced.
FAQs
1: What is an overvalued company?
A company is considered overvalued when it is trading at a higher value than its intrinsic value or real value. Intrinsic value can be calculated using various methods, including discounted cash flows. There is no global standard for overvaluation.
2: Should I short an overvalued company?
Ans- Short-selling an expensive firm is not always the best tactic. The reason for the overvaluation must be explored first. For example, if a stock price is rising due to the approval of a new product, then it is not wise to short it.
3: Why do stocks become overvalued?
Stocks become overvalued when the impact of the latest news or announcement is overestimated by market participants. This can lead to a higher estimation of intrinsic value and a higher price for a stock. This often starts positive feedback loops of buying in anticipation of further price rises.
4: Can we buy undervalued stocks?
Yes, after researching properly and being sure that a stock’s undervaluation is not due to some major negative event, you might consider buying an undervalued stock. Remember that all undervalued stocks are not worth buying and conduct proper due diligence.
5: How to identify overvalued stocks?
To identify overvalued stocks various metrics can be used. Some of these are the price-to-earnings ratio, price-to-book ratio, etc. These are used for comparative analysis and finding the best stocks to trade.
