What Is “Overvalued”?
An overvalued stock has a current price that is not justified by its earnings outlook, known as profit projections, or its price-earnings (P/E) ratio. Consequently, analysts and other economic experts expect the price to drop eventually.
- An overvalued stock has a current price that is not justified by its earnings outlook, typically assessed by its P/E ratio.
- A company is considered overvalued if it trades at a rate that is 50 times its earnings.
- Overvalued stocks are sought by investors looking to short a position, selling shares to repurchase them when the price falls back in line with the market.
Overvaluation may result from an uptick in emotional trading, or illogical, gut-driven decision making that artificially inflates the stock’s market price. Overvaluation can also occur due to deterioration in a company’s fundamentals and financial strength. Potential investors strive to avoid overpaying for stocks.
The most popular measure of a company’s financial strength is the P/E ratio, which analyzes a company’s earnings to its stock price. An overvalued company might trade at a rate that’s 50 times its earnings.
Understanding Overvalued Stocks
A small group of market theorists believes that the market is perfectly efficient, by nature. They opine that fundamental analysis of a stock is a pointless exercise because the stock market is all-knowing. Therefore, stocks may neither be truly undervalued or overvalued. Contrarily, fundamental analysts are staunch in their belief that there are always opportunities to ferret out undervalued and overvalued stocks because the market is as irrational as its participants.
Overvalued stocks are ideal for investors looking to short a position. Shorting entails selling shares to repurchase them when the price falls back in line with the market. Investors may also legitimately trade overvalued stocks at a premium due to the brand, superior management, or other factors that increase the value of one company’s earnings over another.
How to Find Overvalued Stocks
Relative earnings analysis is the most common way to identify an overvalued stock. This metric compares earnings to some comparable market value, such as price. The most popular comparison is the P/E ratio, which analyzes a company’s earnings relative to its stock price. An overvalued company would be one trading at a rate that’s 50 times earnings.
Analysts looking for stocks to short may seek overvalued companies with high P/E ratios, particularly when compared to other companies in the same sector or peer group. For example, assume a company has a stock price of $100 and earnings per share of $2. The calculation of its P/E ratio is determined by dividing the price by the earnings ($100/$2 = 50). So, in this example, the security is trading at 50 times earnings.
If that same company has a bumper year and makes $10 in EPS, the new P/E ratio is $100 divided by $10, or 10 times ($100/$10 = 10). Experts consider the company overvalued if earnings are $2 per share, but undervalued if earnings are $10 per share.
Real World Example
Although by definition, a stock is overvalued only by the opinion of an analyst, The Motley Fool website is never shy about weighing in. For example, they deemed the pharma giant Ely Lilly to be overvalued because the company’s valuation reached “untenable levels following the company’s meteoric rise during the tail end of 2019 and early days of 2020.” According to The Motley Fool, in January 2020, the company’s stock was the second most expensive among its industry peers and Eli Lilly might find it hard to deliver consistent expected growth.