Stocks that have a higher market value compared to its intrinsic value or worth are considered overvalued stocks. Intrinsic value is a company’s original value which primarily depends on factors in its control, i.e. internal factors.
Therefore, the factors which affect a company’s stock prices are referred to as external factors. It includes rise and fall in demand of shares, market fluctuations, unfounded decisions made by investors which inflates the prices of such stocks, etc.
Other than that, stocks can also be overvalued if such a company faces any fiscal or fundamental crises, in which case, it is overvalued due to internal factors.
Several market experts refute the concept of incorrect valuation of stocks – undervaluation and overvaluation – however, several renowned market gurus such as Warren Buffet and Benjamin Graham have employed the practice of value investing, i.e. investment in undervalued or overvalued shares.
In this article
How to Determine Whether a Stock is Overvalued?
When analyzing whether a company is overvalued or not, there are a few parameters or variables thoroughly examined by value investors. These include a company’s balance sheet, annual report, statement of income and other related variables which allows investors to form an idea of a company’s operations, infrastructure, financial and managerial capacity, revenue model, etc.
To develop a more concrete and substantial idea of the factors mentioned above, these metrics are taken into consideration –
- Price-to-earnings (P/E) ratio
It is the ratio between a company’s per-unit share prices and earnings per share received by shareholders. Its formula is –
Share price per unit/Earnings per Share.
If a company’s P/E Ratio is 50, it implies that a shareholder has to pay Rs. 50/share to earn Re. 1/share.
For instance, the price of each share of Company X, as mentioned in the stock market, is Rs. 2000. At the same time, its Earnings per Ratio is Rs. 40. Therefore, the company’s P/E ratio is Rs. 2000/40 or 50.
Investors and analysts consider stocks which have a P/E ratio of 50 or above to be an overvalued share, especially in comparison to a stock which has a ratio at par with or below 10.
As it allows investors to determine that its share prices are considerably higher than what a company can afford to pay as dividends.
- PEG ratio
While P/E ratio is a credible determinant of overvalued stocks, it does not provide profound information about the company which compromises the accuracy of decision-making. On that account, several investors and analysts use the PEG ratio.
It is a ratio between the expected growth rate of Earnings per Share in the following years (minus the payable tax) and the current P/E ratio.
P/E ratio = P/E ratio / Growth rate of the company’s EPS.
In case a company is also in the habit of paying dividends, investors employ the following formula –
Dividend-adjusted PEG Ratio / (Growth rate of EPS + Dividend paid).
Financial experts consider a PEG ratio below 2 to be the threshold; above this, such stock is considered overvalued. Hence, the lower the PEG’s value, the more undervalued it is and vice versa.
- The relative percentage of dividend yield
It is a measurement of how well a company has performed in terms of dividend by drawing a comparison between its current dividend disbursements. In the case of overvalued shares, dividend disbursements are considerably lower than its history. It denotes the fact that although the company’s stocks have been valued substantially, its financial capacity is limited.
Market analysts and value investors derive such conclusions from the fact that even if a company is going through cyclical fluctuations in the market or any fundamental changes with such company, it is historically supposed to maintain a certain level of stability in its dividend payment.
This method is particularly useful for new investors, as it does not include extensive data research but only involves the extraction of the company’s dividend payment history. Investors should duly check the years where such a company has witnessed a dip in its dividend payment to conclude.
- Spotting cyclical fluctuations beforehand
It is also crucial for investors to determine whether the stock market in specific and the economy, in general, would witness any major cyclical fluctuations which will affect the prices of stocks.
In such cases, stock prices of companies belonging from specific industries surges during economic expansion resulting in rapid capital appreciation, high dividends, etc. This phenomenon where only economic expansion causes prices of stocks to grow is referred to as value trap; because, investors decide to purchase these stocks seeing a spike in stock prices but later are trapped as such prices fall incredibly and no one is willing to purchase it.
Who should Invest in Overvalued Stocks?
Individuals who have considerable expertise over the stock market and are inept with its know-hows can decide to invest in an overvalued stock.
It is because such investors possess profound knowledge and would be subject to more certainty regarding whether a stock is undervalued or not.
New or inexperienced investors would struggle to curate, research, and compute conclusive data, which would allow them to make an informed decision.
However, inexperienced individuals can also use the relative dividend yield percentage to decide whether a share is undervalued.
In addition to experience and inexperience, those individuals who already hold overvalued stocks purchased prior to such inflation can also decide to trade those during overvaluation to earn substantially high capital gains.
The best overvalued stocks in India only hold one necessary advantage, which is – if an investor has been in the market for a long period and previously held shares which have been overvalued due to a misinterpreted economic expansion, they can take absolute advantage of it by selling his/her shares.
The disadvantages are –
- Being caught in a value trap, by which an investor might incur considerable losses.
- The requirement of market proficiency to determine whether a stock is overvalued or not.
To conclude, it takes a little bit of experience and expertise to spot and base your bets on an overvalued stock. While going for such a stock, ensure you have analysed the business properly for its fundamentals and growth potential.