An overvalued stock is the share of any listed company that is currently trading above its intrinsic value or true worth. This value can be identified using the company’s earning potential or the value addition it offers its shareholders. When a stock is trading above its actual worth, the rationale is that in the future, when a market correction occurs, the price of the stock may decline to reflect its true value.
So, when you perform fundamental analysis and identify that a stock is overvalued, the consensus is to avoid investing in the company. This sums up the meaning of overvalued stocks and how investors tend to perceive them.
How to determine whether a stock is overvalued?
Fundamental analysis and evaluation of financial ratios can help you identify overvalued stocks easily. Check out some examples of overvalued stocks below and look at the different ways to find out the valuation of a stock.
1. Price-to-Earnings (P/E) ratio
The P/E ratio of a company compares its current market price to the Earnings per Share (EPS). So, it essentially tells you how much shareholders are paying per rupee of earnings they receive from each stock. As a rule of thumb, a higher P/E ratio indicates that the stock may be overvalued because shareholders in the market are paying more money for each rupee of earnings from the company’s shares.
For example, if a stock has a P/E ratio of 40, it means the company’s market price is 40 times its EPS. To decide whether or not this indicates an overvalued stock, you can compare the company’s P/E ratio with the industry’s.
2. Price-to-Book (P/B) ratio
The P/B ratio can also help you identify overvalued stocks. This financial metric compares the current price of a company in the market with the book value per share. By analysing this ratio, you can check the amount that shareholders pay for a share relative to its book value. A high P/B ratio indicates that the stock may be overvalued because you are paying more for it than its book value indicates.
3. Price/Earnings-to-Growth (PEG) ratio
The PEG ratio builds upon the P/E ratio. To compute this metric, you divide the P/E ratio by the rate of EPS growth. In other words, you can use this ratio to see how a company’s value stacks up against its earnings growth. A lower PEG ratio indicates that the company may be undervalued because its P/E ratio is much lower than its EPS growth. Conversely, a high PEG ratio is a possible sign of overvalued stocks.
4. Discounted Cash Flow (DCF) method
In addition to checking financial ratios, you can also use the DCF method to find the valuation of a company. This method involves discounting the future cash flows of a company to their present values to find the true value of the entity (and, thereby, the true value per share). If the market price is above the value per share, you have an overvalued stock.
For example, say the value of a company comes out to be Rs. 20 crores as per the DCF method. Now, if the company has 10 lakh outstanding shares, the true value per share turns out to be Rs. 200. If the current market price of the company’s shares is, say Rs. 320, it indicates overvaluation
Advantage of overvalued stocks
The primary advantage of holding overvalued stocks in India lies in their potential for significant gains during periods of economic expansion. However, this strategy requires a deep understanding of market cycles and the ability to identify and capitalize on mispriced securities. Investors who have held overvalued stocks during previous periods of economic optimism may be able to profit by selling them at peak valuations.
Disadvantages of overvalued stocks
The primary risk associated with overvalued stocks is the potential for significant losses, particularly if the market corrects and the stock price falls back to its intrinsic value. Additionally, accurately identifying overvalued stocks requires a keen understanding of market dynamics and a strong grasp of fundamental analysis. Therefore, it is crucial to conduct thorough research and exercise caution when considering investments in overvalued stocks.
Should you invest in overvalued stocks?
Now that you know the meaning of overvalued stocks and their advantages and disadvantages, you may be wondering if they are good investments. As a general rule, you can consider investing in these stocks if:
- You are aiming for short-term profits
- You have a fairly high tolerance for risk
- You believe that fundamental factors may sustain the stock’s high valuation
- You want to diversify your portfolio, and the overvalued stocks are a part of a broader investment strategy
Conclusion
Identifying overvalued stocks is an essential part of fundamental analysis. If you are planning to invest in certain companies over the long term, it is crucial to be clear about how the market currently values those stocks. This will help you narrow down suitable companies before you invest in the stock market.
That said, keep in mind that overvalued stocks may not always undergo a correction within the investment horizon you have in mind. So, if you assess that some overvalued stocks may have the potential to rise further before declining, your investment strategy can leverage this upside.
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