Overvaluation of stock: Meaning of overvalued stocks

What is an overvaluation of stock?

Overvaluation of stock occurs when stocks have a higher market value as compared to their actual worth. Some of the reasons that lead to stocks being overvalued are a rise in emotional trading or irrational, gut-driven decisions that artificially inflate the stock’s market price, and, last but not least, a company’s financial health and fundamentals deteriorating to the extent that they need to overvalue their stocks. In summary, an overvalued stock is also a type of stock that has a price that is bigger or higher than its real value.

The instances stocks are said to be overvalued are when investor confidence soars, causing a surge in demand, or when a company’s fundamentals rapidly deteriorate while the market price remains stable.

What does overvalued stock mean?

The meaning of overvalued stock is a security that trades at a higher market price than the normal fair value of the stock. There are many stock valuation methods. We will look at each method of valuing stocks, together with their advantages and disadvantages.

Understanding the whole concept and meaning of overvalued stock

In understanding the concept and meaning of overvalued stock, one has to look at the claim made by a few selected market theorists that claim that the market is inherently flawlessly efficient by nature. They argue that because the stock market is all-knowing, fundamental analysis of a stock is useless. As a result, stocks cannot actually be overvalued or undervalued.

On the other hand, we have fundamental analysts that have a contrary opinion to the market theorists. This group of people claims that the market needs to be studied because it is not flawless. Rather, they say the market makes room for the undervaluation and overvaluation of stocks because the market is irrational like the people who are participating in it.

When the market becomes volatile, the astute investor searches for openings. Using a shorting strategy if stocks are overvalued could boost your portfolio returns, but it carries risk. Short-selling entails borrowing stocks, selling them at market value, and then buying them back at a lower cost to give them back to the investment company from which you borrowed them. In the event of a price drop, you profit. If you can pick the right stocks at the right time, this strategy can be profitable. If you’re thinking about using a shorting strategy to profit from market trends, you must be able to identify an overvalued stock.

Shorting overvalued stock in a volatile market

Shorting a stock is based on the idea that you can profit from downward trends. Therefore, if you find an overvalued stock and short it, you could theoretically profit when the price starts to decline.

Because you’re essentially betting that the price of an overvalued stock will fall, short-selling can be risky. You borrow the shares, then you sell them to a customer who is prepared to pay the going rate. Furthermore, if the stock price falls after you sell it, you can buy it back at the new lower price and give the lender the shares. The difference between the buy price and the selling price is where you can profit.

When shorting an overvalued stock during times of market turbulence, the main risk is that a trend could change. You might decide to invest in a stock you believe will drop in value, but if that doesn’t happen and the price of the stock starts to rise instead, you could lose money.

That is why it is crucial to understand how to spot overvalued stocks. Given the speculative nature of this type of investing strategy, it’s critical to reduce the potential for error as much as possible. This entails being able to seize on overpriced stocks that are currently trending downward and are most likely to keep doing so for the foreseeable future.

Overvalued stock formula

Simply divide the current stock price (market value per share) by the earnings per share or the price to book ratio (P/B) and if the P/B ratio exceeds 1, the stock may be overvalued.

The formula for calculating the overvaluation of stock
Formula to calculate for overvaluation of stock.

How to tell if a stock is overvalued

Studying specific ratios can help guide you in the right direction if you’re looking for stocks that are overvalued. When determining whether a stock is overvalued, these ratios can be the most helpful.

Price-to-earnings (P/E) ratio

The price-to-earnings ratio (P/E) is one metric used to determine a company’s stock value. In essence, it describes how much money you’d need to spend in order to make £1 in profit. An elevated P/E ratio may indicate that the stocks are overpriced. As a result, it might be helpful to compare the P/E ratios of rival companies to determine whether the stocks you want to trade are overvalued.

By dividing the market value per share by the earnings per share, the P/E ratio is calculated (EPS). The company’s overall profit is divided by the number of shares it has issued to arrive at the EPS.

Example of a P/E ratio: You purchase XYZ shares for £100 each. With five million shares in circulation, XYZ makes a $2 million profit. Accordingly, the EPS is 40p ($2 million divided by $5 million) and the P/E ratio is 250 ($100 divided by 40p). As a result, for every $1 in profit, you will need to invest $250.

Price-to-earnings-growth (PEG) ratio

The PEG ratio examines the P/E ratio in relation to the annual EPS growth rate as a percentage. A company’s stock may be overvalued if it has below-average earnings and a high PEG ratio.

Example of a PEG ratio: The price per share of Company XYZ is £100, and its EPS is $5. This indicates that the earnings rate is 5% ($5/$100) and the P/E ratio is 20 ($100/$5). In that case, the PEG ratio would be equal to 4 (20/5%).

Price-to-dividend ratio

You might also take into account the price-to-dividend ratio to determine the value of the stock in question that pays dividends to investors. This ratio calculates the cost for an investor to receive $1 in dividends. Dividends are a portion of a company’s profits, but not all stocks have them.

Price-to-sales ratio (P/S)

When the P/E ratio of a stock cannot be determined, the price-to-sales ratio can be used. The price of a share today divided by the number of shares sold is represented by this ratio. A stock may be overvalued if the ratio is high, which increases the likelihood of this.

Price-to-book ratio (P/B)

The company’s P/B ratio can be used to determine a stock’s true value. This ratio is used to compare the market price to the book value of the business (total assets minus liabilities, divided by the number of shares issued). Divide the market price per share by the book value per share to arrive at the figure. If the P/B ratio exceeds 1, the stock may be overvalued.

Example of a P/B ratio: ABC’s shares are trading at $50 per share and have a $30 book value per share, making the P/B ratio 1.67 ($50/$30).

Return-on-equity ratio (ROE)

ROE, which is calculated as a percentage, measures a company’s profitability in relation to its equity. It is calculated by dividing net income by stakeholder equity to get the return on equity (ROE). A low ROE might be a sign that the shares are overpriced. This is because it would indicate that the company isn’t making a lot of money in comparison to the amount invested by shareholders.

Example of ROE: ABC has a net income of $100 million (income minus liabilities) and stockholder equity of $120 million. Because of this, the ROE is 83 percent ($100 million/$120 million).

Debt-to-equity ratio (D/E)

The D/E ratio compares the debt of an organization to its assets. A lower ratio may indicate that the majority of a company’s funding comes from its shareholders, but this does not necessarily imply that the stock is overvalued. A company’s D/E ratio should always be compared to the average of its competitors to determine if there’s an overvaluation of stock. This is so that a “good” or “bad” ratio can vary by industry. Divide liabilities by stockholder equity to get the D/E ratio.

Example of D/E: ABC has $1 billion in stockholder equity and $500 million in debt (liabilities). The D/E ratio ($500 million/$1 billion) would be 0.5. This indicates that for every $1 of equity, there is $0.50 in debt.

​Earnings yield

The earnings yield essentially functions as the P/E ratio’s opposite. Instead of dividing the price per share by earnings, it is calculated by dividing EPS by the share price. If the average interest rate the US government pays on its borrowings (also referred to as the treasury yield) is higher than the earnings yield, some traders believe that the stock market is overvalued.

Example of an earnings yield: ABC’s share price is $60, and its EPS is $20. The earnings yield ($20/$60) will be equal to 33 percent.

Current ratio

The current ratio is a metric used to assess a company’s debt-paying capacity. It is calculated by merely subtracting liabilities from assets. A current ratio greater than 1 typically indicates that the available assets are sufficient to cover liabilities. The likelihood that the stock price will increase going forward, possibly even to the point of overvaluation, increases with the current ratio.

Example of current ratio: ABC has assets worth £1.8 billion and liabilities worth $1 billion (debt), so the current ratio is equal to 1.8 ($1.8 billion/$1 billion).

Relative dividend yield

The company’s P/B ratio can also be used to determine a stock’s true value. This ratio is used to compare the market price to the book value of the business (total assets minus liabilities, divided by the number of shares issued). Divide the market price per share by the book value per share to arrive at the figure. If the P/B ratio exceeds 1, the stock may be overvalued.

Example of a P/B ratio: ABC’s shares are trading at $50 per share and have a $30 book value per share, making the P/B ratio 1.67 ($50/$30).

Analyze the fundamentals

You’ve probably already heard the term “fundamental analysis,” which is understandable given that it’s a crucial step in stock analysis if you want to make long-term investments.

For those of you who are unfamiliar, fundamental analysis entails examining a company’s financial statements. These comprise balance sheets, income statements, cash flow statements, debt-to-equity ratios, and other quantitative and qualitative elements that assess the general health of a stock.

Once you’ve fully grasped the fundamental analysis process, determining a stock’s fair or intrinsic value will be much simpler for you to do. From there, comparing the intrinsic value to the stock’s current price will be a piece of cake.

Overvalued stock example

Let’s use an example to better illustrate everything we’ve been discussing.

  1. Medical tool supplier Teleflex (TFX)  has over 12,000 employees, with annual revenue of over $2.4 billion, and has been a member of the S&P 500 index since 2019. The Teleflex stock rose without any justification as a result of a number of factors, including unfounded optimism for medical stocks in the wake of COVID-19. Naturally, the metrics and ratios reflected this, and once investors realized the stock was overvalued, there was a sharp price decline. The stock price of Teleflex decreased from $417 to $375 in just five days, from July 14 to July 19 of 2021.
  2. Let’s say, for illustration, that you think Company XYZ is worth $50 per share. However, XYZ stock is currently trading at $100 per share. In this situation, XYZ stock would be regarded as being overpriced.

Overvaluation of Stock: Advantages and disadvantages

Understanding the business, what makes it profitable, the current environment that is favorable for it, and what changes could affect the profitability are the keys to determining whether a company is valued appropriately. Therefore a list of the pros and cons of overvalued stock will be given.

Advantages of overvalued stock

  • First off, if the stock price is truly out of proportion to the company’s earnings, the stock price may rise in the future as the earnings increase.
  • Second, a large group of investors and analysts frequently follow overvalued stocks. This may offer the stock some support and stability as well as information and viewpoints that other stocks might not have.
  • Third, you can profit if the price of an overvalued stock declines by shorting it. By betting against a stock if the market recognizes that it is overvalued and the price drops.
  • Finally, because overvalued stocks are more volatile than other stocks, they may offer more chances for quick gains through day trading or other techniques.

Disadvantages of overvalued stock

  • The biggest drawback of investing in overvalued stocks is the increased likelihood of financial loss.
  • One of the biggest dangers is that the company’s fundamentals might not get better, which would mean that the stock price might keep falling.
  • Another drawback of overvalued stocks is that it might be challenging to sell them if you can’t find a buyer.
  • Last but not least, even if the business starts to expand, the stock price might not rise at the same rate.

Pros and cons of overvaluation of stocks

Pros of overvalued stockCons of overvalued stock
Increased chances of financial gain from shortingHigh risk of financial loss
Attracts a large group of investors which gives the stock support and stabilityStock prices might fall due to the company’s fundamentals failing
The stock price may rise as future company earnings increasesVery hard to sell when the stock starts to decline
They are the best stocks for quick tradingThe stock price might not increase in the same proportion as the business expands
Pros and cons of overvalued stock

How to trade overvalued stocks

  • Short selling
  • Options

The above-listed are the ways one can use to trade overvalued stocks.

Short selling

Starting with the most important technique, short selling. This phrase may be familiar to you; the recent GME short-selling squeeze unexpectedly brought short selling to the forefront. So how does it function?

Simply put, when you short-sell security, you borrow it and then sell it right away. If your prediction was accurate and the price of the overvalued stock declines, you’ve made a profitable move. However, due to the terms of short selling, you are required to return the stock to its previous owner within a certain timeframe.

Let’s use a fictitious instance. When the stock is currently trading at $20, you borrow it from another trader. You sell it right away, and after a few days, the cost falls to $14. At that point, you can purchase it for $14, return it to the lender, and keep the $6 profit. If you multiply that by 100 or assume you borrowed 100 shares, you would have earned $600.

Gains can be made by short selling, but this is a risky trading strategy and requires skill, perseverance, and lots of practice. Short-selling has unlimited potential for loss because you will suffer losses if the stock price increases. And as the recent GMA scandal shows, stock prices can suddenly soar to absurd heights.

Options

Investors can trade overvalued stocks using options, specifically put options, in addition to short selling. As derivatives, options are sophisticated financial instruments whose value is determined by the value of an underlying asset, in this case, a stock.

The ability (but not the obligation) to buy or sell a stock at a predetermined price by a predetermined date is provided to the investor by options. In essence, options allow you to profit from price movement if you believe you can predict what a stock’s price will be by a specific date in the future.

The right to sell a stock at a predetermined price is provided by put options. Buying a put option might be a wise move if you believe that a stock’s price is excessive and will consequently decline.

Let’s take a stock that is currently trading at $45, but you believe it to be overvalued. When the stock price drops to $38 over the course of a few days after you purchase a put option entitling you to sell it for $42, you have the option to do so. You would have two options in this scenario: sell the actual options contract for a profit, or, if you own the stock, secure a profit of $4 per share.

Is an overvalued stock good or bad?

Answering this question is challenging because it depends on the specific stock and situation.

In general, an overvalued stock is one that is trading above its true value. Several factors, including investor optimism or irrational exuberance, may be to blame for this. Because a price correction could occur, overvalued stocks can be risky.

This implies that there is a chance of a sudden, unexpected drop in stock price. For investors who are unprepared, this could be devastating. If you want to position your portfolio for long-term growth and lower risk, you should avoid overvalued stocks.

Conducting your own research is crucial if you want to safeguard yourself from overvalued stocks. Examining the financial statements, comprehending the business model, and taking the macroeconomic environment into account are all part of this.

As was already mentioned, professional short sellers frequently target overvalued stocks. This is due to the fact that overvalued stocks frequently decline over time to their intrinsic value. Therefore, you should steer clear of overvalued stocks if you intend to buy and hold a stock for a long time.

Overvalued vs undervalued stock

Most often, stock analysts use one of the many valuation models that aim to forecast a stock’s direction when they discuss whether a stock is either undervalued or overvalued. Since it is expected that undervalued stocks will rise and overvalued stocks will fall.

Overvalued stockUndervalued stock
The meaning of overvalued stock is a security that trades at a higher market price than the normal fair value of the stock.Undervalued stock is a security or other investment that is trading in the market for a price that is thought to be below the investment’s true intrinsic or fair value.
Overvalued vs Undervalued Stock

Is it better to buy undervalued or overvalued stocks?

Purchasing undervalued stocks is generally a better option. This is due to the higher margin of safety they offer and the fact that they typically outperform overvalued stocks over the long term.

This is due to a number of factors. In the first place, an undervalued stock has a lower downside risk.

This is due to the fact that the stock is currently trading below its intrinsic value. Second, the market frequently overlooks undervalued stocks. As a result, there will be less competition when you try to purchase the stock.

As more and more investors start to buy the stock as they become aware of its potential, the price will rise. Last but not least, undervalued stocks are typically of a higher caliber than overvalued stocks. This could be because they aren’t following the most recent trend or bubble. Instead, they usually represent businesses that are trading at a discount and have strong fundamentals.

A company that is trading at a 50% discount from its intrinsic value, for instance, is probably a better investment than one that is trading at a 20% premium. Companies with overvalued stocks frequently show no immediate signs of profitability.

In the past, undervalued stocks have consistently outperformed overvalued stocks. Therefore, it is best to concentrate on undervalued stocks if you intend to invest for the long term.

Tips for checking if a stock is overvalued

  • Take a look at treasury bond yields
  • Economic cycles
  • Don’t fall into a value trap

Take a look at treasury bond yields

According to the general rule of thumb, when a stock’s earnings yield is three times lower than a treasury bond yield, things have already spiraled out of control. This indicates that there is a significant mismatch between the stock’s intrinsic value and its price, and the stock in question is unquestionably overvalued.

For instance, if a company’s diluted earnings per share (EPS) is $1 and the yield on 30-year Treasury bonds is 5%, the test would indicate that the stock is overpriced if you paid $40 or more per share: [(2/.05)/1 =40]. That raises a warning sign that the expectations of your returns are unrealistic.

Economic cycles

When examining a specific stock, it’s important to consider the overall picture. Numerous metrics that we rely on when dealing with overvalued stocks can have their meanings distorted by economic cycles, regardless of whether the economy is growing or in a recession.

Don’t fall into a value trap

Companies that build homes, make cars, or manufacture steel all have distinctive characteristics. When business is bad, these companies frequently experience abrupt drops in profit. In periods of expansion, they also experience significant increases in profit. When the latter occurs, you might be lured in by what seem to be rapidly increasing earnings, low P/E ratios, and, occasionally, sizable payouts.

However, when this occurs, it is referred to as a “value trap,” and it can be dangerous. These pitfalls can snare new investors because they emerge at the end of economic expansion cycles. If you’re wise, you’ll realize that these companies’ P/E ratios are actually much higher than they seem.

Conclusion on overvaluation of stock

One should be aware that overvalued stocks are more likely to see their prices fall in the future. This is due to the fact that their prices are not backed by underlying factors like earnings and dividends. In essence, overvalued stocks carry risk.

FAQ on overvalued stock

Is stock market overvalued?

The stock market is currently overvalued, which is a sign that investors are favoring momentum trades over fundamental analysis.

Are stocks overvalued?

Yes, stocks are overvalued in today’s stock market. Therefore, it can also be referred to as an overvalued stock market.

A video on how to check if there is an overvaluation of stock in the stock market.
Last Updated on August 12, 2022 by Nansel Nanzip Bongdap