How to Identify Overvalued Stocks
Although their existence may be questionable to some, overvalued stocks are the result of mispricing in the financial markets. But how is it possible for a stock to be incorrectly priced? In this article, we will explain exactly what overvalued stocks are, how they become overvalued and methods by which they can be identified by traders and investors!
Table of Contents
What Is an Overvalued Stock?
Amongst the multitude of market participants, there are people who believe that the financial markets are perfectly efficient. In other words, they believe that every piece of available information is already accounted for and reflected in an asset’s price.
It is an interesting position to hold - because, in order for the markets to be perfectly efficient - it would require buyers and sellers to be fully informed and to act rationally all the time. Are humans always rational? Is it true that buyers never pay too much for an asset? Do sellers never accept too little?
A fundamental analyst would answer “No!” to those questions and - this is, essentially - the central tenet of fundamental analysis; the belief that perfect efficiency does not exist in the financial markets; that the price of an asset does not always reflect its true value. Moreover, fundamental analysts believe that, over time, an asset’s price will always correct itself, allowing savvy traders and investors to exploit discrepancies between price and value for profit.
So what do we mean by an overvalued stock? Whilst people who believe the financial markets are perfectly efficient would argue that no such thing exists, for the rest of us, an overvalued stock is a stock whose price is higher than its intrinsic value. How can overvalued stocks be identified? Before we look at this, let’s briefly look at why a stock might be overvalued in the first place.
Why Would a Stock Be Overvalued?
As with any asset, a stock’s price is determined by levels of supply and demand in the market. Therefore, whenever demand outstrips supply, the stock will increase in price and, sometimes, this price increase does not accurately reflect the intrinsic value of the stock.
This can occur when the stock in question is receiving a lot of positive publicity or if the particular stock, or its industry, becomes trendy amongst investors. Either way, when lots of investors begin demanding the stock, of which there is only a finite supply, it drives its price up and can lead to it becoming overvalued.
This scenario of an increase in demand leading to a stock becoming overvalued has been particularly well-publicised in recent months with so-called “meme stocks”, where amateur investors have targeted particular companies, such as GameStop, and caused their share price to shoot up to levels which were not necessarily justified by the company’s fundamentals.
There may also be more legitimate reasons for overvalued stocks to exist. For example, if a company has a strong, reputable brand, investors may place a higher value on their shares than the fundamentals would otherwise support.
How to Identify Overvalued Stocks
So, now we know what an overvalued stock is and why a stock might be overvalued, how can we identify overvalued stocks?
There are various ratios which can be used to attempt to identify overvalued stocks; below are listed some of the most common, which we will explain further in the following sections.
- Price to Earnings Ratio
- Price/Earnings to Growth Ratio
- Price to Sales Ratio
- Return on Equity
- Earnings Yield
Price to Earnings Ratio
The Price to Earnings ratio, or simply P/E, is one of the most commonly used ratios for analysing overvalued stocks. The P/E ratio can be found by dividing the current share price of a company by its Earnings per Share (EPS) and, therefore, allows investors to compare the current share price with the level of earnings which the company has achieved. The higher the P/E, the more “expensive” a stock is perceived to be.
For example, if Company X’s current share price is £100 and their EPS is £5, then the P/E is equal to 20 (100 / 5 = 20).
So, what P/E would indicate that a stock is overvalued? Unfortunately, as will be a theme in this list, there is no exact level of P/E which is universally considered too high; it can depend on the company, industry and investor in question. The best way to analyse whether a P/E indicates a stock is overvalued is to compare it with other companies which operate in the same industry, this should help paint a clearer picture of whether the stock in question is overvalued. It is also a good idea to compare the result with other ratios, like the next one on our list.
Price/Earnings to Growth Ratio
The Price/Earnings to Growth (PEG) ratio is calculated by dividing the P/E by EPS Growth over a set period of time, usually 12 months. It essentially helps put a stock’s P/E and EPS into perspective, by comparing them with the rate at which EPS is growing.
Continuing with our previous example, Company X has a P/E equal to 20. It’s current EPS is £5 and let’s say that 12 months ago, it’s EPS was £4 – meaning that it has grown by 25%. The PEG, therefore, is equal to 0.8 (20 / 25 = 0.8).
A higher PEG can indicate overvalued stocks, particularly when coupled with a lower than average EPS. Again, in order to evaluate what is “high” or “lower than average” one must compare with companies that operate in the same industry.
Price to Sales Ratio
Unlike the P/E, the Price to Sales ratio (P/S) does not take into account a company’s earnings and instead compares the current share price to its revenue. P/S can be used to identify overvalued stocks when a company does not have earnings but it does have revenue. So it is particularly useful for evaluating the shares of a start-up company.
The P/S is calculated by dividing current share price by sales per share (i.e. total sales / total number of shares outstanding). Let’s say that Company X’s current share price remains £100 and their sales per share is £10. Its P/S, therefore, would be equal to 10 (100 / 10 = 10).
As with P/E, a comparatively higher P/S can be a sign of overvalued stocks. However, it is important to use P/S in conjunction with other analysis. Strong sales and a low P/S is only valuable if at some point the company is able to translate this into an increase in earnings. Otherwise, no matter how large the sales volume and how “cheap” the stock seems, the company will not be a successful investment.
Return on Equity
Return on Equity (ROE) is a frequently used measure of how a company is currently performing. Although the calculation does not take into account the current share price, it can be used in conjunction with other ratios and compared with the current share price to make a judgement on whether a stock is overvalued.
To calculate ROE, you must divide a company’s net income by its shareholder’s equity, where shareholder’s equity is a company’s assets minus its debt (it can be found in a company’s annual accounts). ROE can be used to demonstrate how efficient a company is in creating profits, where essentially the higher ROE the better. A low ROE, combined with a high share price could lead us to deduce that a stock is overvalued.
The earnings yield is the inverse of the P/E, which we have already looked at. Instead of dividing the current share price by EPS, the earnings yield is calculated by dividing EPS by the current share price.
For example, going back to Company X, which has a current share price of £100 and an EPS of £5, their earnings yield would equal 5% (5 / 100 = 0.05).
The earnings yield is a useful figure, as it allows investors to easily compare potential returns between different instruments. The earnings yield of 5% essentially tells us that, for every £1 invested, an investor can expect approximately £0.05 of earnings for the company.
So, what value can be used to highlight overvalued stocks? Again, there is no one answer here. However, the useful thing about the earnings yield, is that it can be easily compared with bond yields as well as the base interest rate. To some people, stocks which have an earnings yield lower the current base interest rate might be considered overvalued, but again, this is just one measurement and should be used along with others before drawing any conclusions.
Anyone who has been following the financial markets for a while, will know that there are times when investors are optimistic and keen to invest and other times when they feel pessimistic and less willing to invest. Obviously, these market cycles have an impact on prices and valuations.
Whilst you should compare the above ratios across different companies as described above, there are times when most stocks look expensive and times when most stocks look cheap.
In order to get a better handle on where in this recurring market cycle you are, it is worth looking at these measures over time.
The chart below tracks the P/E ratio for the whole of the S&P 500 over time.
In it you can see every famous bubble and its demise clearly illustrated: the roaring 1920s, Black Monday in 1987, the internet bubble which popped in 2001 and the most recent financial crisis of 2007/08.
Looking at figures like PE, over time, can give you a very good idea about whether a stock is overvalued, compared to the market’s long-term average, not just compared with today’s prices.
How to Attempt to Profit From Overvalued Stocks
When identified, traders can attempt to profit from overvalued stocks by taking a short (sell) position against them. Traditionally, in order to do this, traders would have to borrow the stock from an existing shareholder and sell it to a third party, with the expectation that when the share price fell, the stock could be repurchased for a lesser amount.
However, the growth of financial derivative products have simplified this process. For example, with Contracts for Difference (CFDs) traders can attempt to profit from both rising and falling prices without ever owning the underlying asset. Furthermore, CFDs benefit from the use of leverage.
With a Trade.MT5 account from Admirals, you can trade CFDs on over 3,000 stocks as well as a range of other financial instruments, such as Forex and commodities. In order to start shorting stocks, follow these steps:
- Open a Trade.MT5 account with Admirals
- Download and open the MetaTrader 5 trading platform
- In the Market Watch window on the left hand side of the screen, scroll to the bottom and search for the stock you wish to trade. Once located, highlight it and hit enter on your keyboard to add it to the list of symbols
- Right-click on the symbol and click ‘Chart Window’ in order to open a price chart
- At the top of the screen, press the ‘New Order’ button. An order screen will open, shown below; here you can enter the amount of shares you wish to short and select a stop loss and a take profit. Once you are happy with your order, press ‘Sell by Market’ in order to send your short trade off to the market
Why Trade With Admirals?
As well as being able to trade over 4,000 CFDs on various markets – including Forex, stocks and commodities – Trade.MT5 account owners also benefit from the following:
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.