Stocks go up and down all then time. But how to tell if a stock is overvalued or undervalued at any point in time? And why does that even matter?
When volatility starts to rise, the skills needed to understand a company’s fundamentals are more important than ever. And we’ll explore how to do that in this article.
Let’s get into it.
When Is a Stock Considered Overvalued?
The first thing to understand about whether a stock is considered overvalued is that there isn’t a firm point where a stock is suddenly given a label of “overvalued.”
It’s something that happens over time.
Let’s start with a refresher on earnings because that’s where all analysts will start.
“Earnings” generally refers to a firm’s Net Income. Note that this is totally different from cash flows.
We have a separate article on cash flow vs net income but the gist of it is that “earnings” refers to Net Profit (aka Net Income). And that is different from a firm’s cash flows.
Now, when analysts look at “earnings,” they’ll often read the value in conjunction with a firm’s stock price.
Put differently, analysts often tend to focus on the stock’s price-to-earnings ratio.
This takes the prices and earnings of all listed companies and allows investors to essentially compare apples to apples.
When the company is reporting stronger earnings, the stock price will typically rise as well since investors will see this as an indicator that the company will grow in the future.
As the stock gets traded back and forth, the stock price and earnings start to diverge. This is especially true with companies that continue to show strong growth since investors keep pushing the stock price up faster than earnings are rising.
Stock price is supposed to show not only the current value of a company but also the market’s opinion of future value, so strong companies will have stock prices that are naturally higher than its current actual market value.
However, when the stock’s price starts to become several times higher than the company’s reported earnings-per-share, that will start to point to an overvalued company.
Analysts will review several data points to figure out when a company might be considered overvalued. In a nutshell, if the math surrounding a company’s earning potential simply doesn’t support the stock price, then the company is overvalued.
Let’s look at what those data points are.
Tools to Find Overvalued Stocks
The earnings per share and price-to-earnings ratio are fairly superficial and aren’t the only two metrics analysts use to find out whether a stock is overvalued.
At the end of the day, it also depends on the rate of a company’s growth and whether that growth could support a higher stock price.
The price/earnings to growth ratio (PEG) is one tool investors can use to analyse the price-to-earnings of a company and decide if it’s at a reasonable level.
While the interpretation of the actual figure is somewhat subjective, a PEG of 2 or more is generally considered overvalued.
To find PEG, simply divide the P/E ratio by the company earnings growth rate. Both of these figures can be found on most stock analysis websites or tools.
Let’s take Netflix as an example. As of the the time of writing, the stock was priced at $384.36.
It has a P/E ratio of 35.25 and a projected growth of earnings of 16.86% over the next five years.
You divide 35.25 by 16.86 and you get a PEG or 2.09.
Now, this doesn’t mean you should sell it immediately. But it does point to the possibility that Netflix might be overvalued.
Investors can also look at the dividend yield if the company pays dividends to shareholders for input.
Typically, if the dividend is low, that means the company earnings per share are a bit low which points to being overvalued.
How Investors Should View Overvalued Stocks
Investing is about understanding the company you’re investing in.
If you’re active with rebalancing your portfolio, then you should be regularly reviewing your holdings and looking at specific data points to find out where in a particular cycle your investments are valued.
If a company is overvalued, that does not mean to sell all of your shares and move on to the next undervalued stock.
Going back to our example of Netflix, that company has been rising in price for quite some time.
Even though the PEG shows it might be overvalued, it experienced a 21.79% drop in price in a single day!
Notice from the chart below that the price of Netflix as of the 20th of January 2022 was $508.25
A day later, on the 21st of January 2022, the stock price traded at $397.50 (a decrease of 21.79%).
If you’re wondering how we got the 21.79%, you’ll want to learn how to calculate stock returns.
The fact that the stock fell by that much in a single day means one of two things:
- Netflix stock price climbed well past overvalued territory before collapsing, or
- Investors received new information which confirmed significantly adverse effects to Netflix’s future cash flows and expectations.
The issue with the PEG is that it doesn’t always accurately reflect whether a stock is under or over valued.
If you’d sold all of your shares right when it passed a PEG ratio of 2, you may well have missed out on significant growth!
Take for example this longer-term view of Netflix stock price:
Suppose the PEG (or another ratio for that matter) gave you a “signal” that Netflix was overvalued as of the 20th of February 2020.
If you sold it, you’d have lost the growth going up from $380.40 all the way up to $690.31.
The smarter thing to do is to do a partial withdrawal of an overvalued stock but leave some of it to grow.
This is all assuming you’ve done your homework on the company, and you still believe it’s a stock worth holding.
When Is a Stock Considered Undervalued?
While it’s natural to assume that an undervalued stock is just the opposite of an overvalued stock, that’s not necessarily the case.
A stock that is overvalued can be supported by maths that are available to all investors.
A stock that is undervalued really requires homework on the part of an investor to understand not only the maths but also the reasons that might be surrounding a company’s low value.
Valuing stocks takes some experience to fully understand. Just look at Warren Buffett, the master of undervalued stocks.
If few others can do what he does, it’s obviously not something you can just pick up after a few minutes of online research.
Take some time to learn the tactics that can help you understand how to value stocks, and it will lead to higher-than-average returns in your portfolio.
Our course on stock valuation teaches you how to the power of the Law of One Price and Multiples to identify undervalued stocks from scratch.
If you’re genuinely interested in learning how to tell if a stock is overvalued or undervalued, do check out the course.
Tools to Find Undervalued Stocks
An overvalued stock could realistically be defined simply by looking at the P/E ratio and comparing it to peer companies without really needing the PEG ratio.
For an undervalued stock, the PEG ratio is even more important since you need to understand if the company’s growth is expected to outperform or underperform over the next 5 years.
If a stock is priced low after a huge drop, it doesn’t necessarily mean the stock is undervalued.
It may just mean the company recently lost a huge revenue generating business and is now priced accurately based on the fundamentals.
Subjectively speaking, a PEG ratio below 1 may point to a company that is undervalued.
A PEG ratio of below 1 means that the expected growth rate is actually higher than the reported price to earnings.
Remember earlier we said that stocks are typically priced above the current market value of the company to account for future growth?
A PEG of 1 or below basically means the stock is priced at current market value of the company without taking into account future growth potential.
How Investors Should Trade Undervalued Stocks
Undervalued stocks are any investor’s bread and butter.
It’s great to find them, but it takes a bit more research than simply running numbers.
If you manage to find an undervalued stock, then the obvious answer is to buy it, assuming you understand how the company works.
Speaking of Warren Buffett, he would advise investors to choose a few strong companies to invest in rather than hundreds of diversified companies.
This is indeed his own approach, as can be confirmed by exploring the Berkshire Hathaway portfolio.
Owning fewer companies will also allow you the time to stay updated on changes that may occur to the companies you invest in.
Note that you should still aim to have a diversified portfolio. Don’t ever put all your eggs in one basket.
What About Technical Analysis?
Many trading coaches will give you technical indicators like Relative Strength Index (RSI), Exponential Moving Averages (EMAs), and Bollinger Bands.
These indicators are, for the most part, pointless.
There is no statistical proof that these indicators reflect a company’s value and should be avoided by serious investors.
Obviously, the next thing for your to do is start checking your portfolio using the methods we talked about.
This is only the start of what you need to know in order to see above average returns.
Remember that there is much more to understand before you go out and find overvalued and undervalued stocks.
But, as with most things, the first step often tends to be the most challenging.
So go ahead now, take the first step, and start to identify undervalued stocks!