There are different classes of stocks in the market but overvalued and undervalued stocks are the two types of stocks based on fundamentals. Stock fundamentals are the analysis of data apart from the trading pattern of stock that can impact the price of the stock. The essence of stock fundamentals is to predict and understand the intrinsic value of stocks based on an in-depth analysis of several quantitative, qualitative, economic, and financial factors.
Some market theorists are of the opinion that by nature, the market is perfectly efficient. So, they believe that since the stock market is all-knowing, carrying out a fundamental analysis of a stock is a pointless exercise. Therefore, to them, stocks may neither be truly overvalued nor undervalued. Contrary to this school of thought, fundamental analysts are staunch in their belief that the market is as irrational as its participants. So, they believe that there are always opportunities to search out overvalued and undervalued stocks.
This article will discuss what overvalued and undervalued stocks are in the market and how to determine them.
What are overvalued and undervalued stocks?
According to fundamental analysts, stocks could be overvalued or undervalued by the market. Overvalued stocks are those stocks that trade higher than their fair market value, i.e. they sell at a current price that is not justified by their price-to-earnings (P/E) ratio or profit projections (earnings outlook). Undervalued stocks, on the other hand, are stocks that trade at a price that is significantly below their assumed intrinsic value, i.e they sell at a price that is below the investment’s true intrinsic value.
Take, for instance, a stock that is worth $200 based on predictable future cash flows but is selling at $150 in the market. Analysts would consider this stock to be an undervalued stock. This kind of discounted price associated with the stock is what makes undervalued stocks attractive to investors. They invest in them because they believe that the market prices of the stock will correct over time to show the true fair value of the stock, therefore, creating opportunities for profit.
An example of stock, on the other hand, that is traded at $180 and has earnings per share (EPS) of $6, may be seen as overvalued. This is because, with an EPS of $6, the price-to-earnings ratio of the stock will be 30. The price-to-earnings ratio is calculated by dividing the price of the stock by its trailing 12 months’ earnings per share (i.e market value of the stock of $180 / EPS of $6 will give 30). Therefore, the stock is trading in the market at 30 times more than its actual earnings. This means the stock is overvalued and may find it hard to deliver consistent expected growth.
How do stocks become overvalued?
The stocks that are trading at a current price that is not justifiable by their profit projections or price-to-earnings (PE) ratio are considered overvalued. Overvaluation of stock happens when stocks have a higher market value relative to their actual worth. There are two common factors that cause stocks to become overvalued in the market:
- A surge in demand: Stocks can become overvalued in the market when the confidence of investor soars and cause a surge in demand. The investor’s perception of the company which is not justified by the actual financial status of the company can drive a surge in demand for the stock. Therefore, a rise in emotional trading or irrational, gut-driven decisions are some of the reasons that artificially inflate the stock’s market price. Thus, causing the stocks to become overvalued.
- Declination of company’s fundamentals: A stock can become overvalued if the company’s financial health and fundamentals such as growth projection, revenue, etc decline as its market price remains constant. More so, the financial health and fundamentals of a company may deteriorate to the extent that the company may need to overvalue its stocks.
Whatever the case may be, it’s essential to note that in the near future, an overvalued stock is likely to experience a price decline, which will reflect the true financial status of the company. Therefore, investors must be cautious while investing in overvalued stocks.
How do stocks become undervalued?
Undervalued stocks are just the opposite of overvalued stocks, thus, they trade at the price lower than their fair market value. Undervaluation of stocks can be due to factors such as negative press, recognisability of the company, and market crashes causing stocks to trade at a lower price than their actual value. Here are several reasons that cause stocks to become undervalued in the market:
- Changes to the market: Market crashes or corrections are changes to the market that could cause the prices of stocks to fall.
- Sudden bad news: The prices of some stocks can be affected by bad press, as well as economic, political, and social changes, which causes them to be undervalued in the market. A discrete event that is not even related to the company’s fundamentals such as a public relations disaster or missed guidance can drive the market to undervalue the stocks of the underlying company. Therefore, causing the stocks to become undervalued.
- Misjudged results: Undervaluation of stocks can occur when stocks don’t perform as predicted. The prices of the stock tend to fall as they are misjudged by the market.
- Cyclical fluctuations: These are the alternating periods of contraction and expansion in the business cycle that can last 18 months or longer from the peak to the trough of the cycle. Some industries are very sensitive in such periods. Therefore, during contraction, consumer and business demand tend to drop and then rise during expansion. Due to this, the stocks of such industries e.g cyclical stocks will perform poorly over certain quarters, thus affecting their share prices. However, these stocks tend to pick up when the economy is booming.
Difference between undervalued and overvalued stocks investment
Whether or not one should invest in overvalued or undervalued stocks would depend on the investor’s kind of investment style. The difference between undervalued and overvalued stocks investment is based on typically different styles of investment.
Overvalued stocks investment
Investing in overvalued stocks is best for investors looking to short a position. To short a position involves selling shares to capitalize on expected price declines. They may also legitimately sell these overvalued stocks at a premium due to the superior management, brand, or other factors that increase the value of a company’s earnings over another.
When an investor short-sells a stock, he borrows it and then sells it right away. The investor tends to make a profitable move if his prediction was accurate and the price of the overvalued stock declines. Nevertheless, due to the terms of short selling, the investor is required to return the stock within a certain time frame to its previous owner.
Another investment strategy associated with overvalued stocks is for investors to trade the stocks using options, in addition to short selling. Options provide the investor with the ability (but not the obligation) to trade a stock at a predetermined price by a predetermined date. Therefore, options allow the investor to profit from price movement if the investor believes he can predict what the price of a stock will be in the future at a specific date.
Undervalued stocks investment
Undervalued stocks investment is best for value investors. These kinds of investors go by an investment strategy that entails buying stocks that seem to be trading less than the company’s intrinsic or book value which is referred to as value investing. They believe that the market overreacts to good and bad news, which causes changes in the stock price of a company that doesn’t correspond to the company’s long-term fundamentals. Therefore, they scout for stocks that they think the stock market is underestimating such as value stocks.
The overreaction and inefficiency of the market give value investors an opportunity to make a profit from undervalued stocks. They buy the stocks put on sale at discounted prices and stand a better chance of earning high returns on their investment in the near future. Undervalued stock investment can prove to be profitable because the prices of the stock are expected to go up in the near future. However, when investing in undervalued stocks, it is important to note that a cheap stock may not necessarily be an undervalued stock.
Investing in undervalued stocks entails looking for quality stocks that are selling at a price that is below their fair value. Therefore, it is not just about looking for any stock with a low price. It entails looking for quality stocks because, in the long run, good quality stocks will definitely rise in value.
How to calculate overvalued and undervalued stocks
- Calculate the price-to-earnings (P/E) ratio
- Find the PEG ratio of the company
- Calculate the price-to-book (P/B)
- Find the company’s price-to-dividend ratio
- Find the debt-to-equity ratio (D/E) of the company
- Calculate the return-on-equity ratio (ROE)
- Calculate the company’s price-to-sales
- Find the enterprise value-to-sales of the company
- Calculate the company’s EV-to-EBITDA
Listed above are the various ratios used to calculate overvalued and undervalued stocks. These ratios can be used to determine if a stock is overvalued or undervalued. For investors in the stock markets, determining the intrinsic value of a stock is crucial in trying to find out if the stock is overvalued or undervalued. The intrinsic value of a company is its calculated value using fundamental analysis that takes into consideration a lot of quantitative factors. The intrinsic value of a company is usually different from its current market value.
Many analysts and investors usually make use of a variety of ratios to provide a quicker and easier estimation of a stock’s price. This ratio analysis is also usually viewed in conjunction with intrinsic value calculations. There are basically, 100s of ratios that investors can study or use in different types of analysis. However, a few popular ratios that can provide some quick insight into whether a stock price is overvalued or undervalued include the price-to-earnings (P/E) ratio, PEG ratio, price-to-book (P/B), and the price-to-dividend ratio.
Furthermore, there are alternative methods to calculate overvalued and undervalued stocks using ratios due to the fact that some companies don’t have a net income, operating income, or free cash flow. More so, these companies may also not expect to generate net income, operating income, or free cash flow far into the future. This scenario is likely for companies recently listing initial public offerings, companies that may be in distress, and private companies. Therefore, certain ratios such as price-to-sales, enterprise value-to-sales, and EV-to-EBITDA are considered to be more comprehensive than other ratios for such companies. Hence, they are better for use in alternative valuation methods.
How to calculate overvalued and undervalued stocks using the price to earnings (P/E) ratio
The price-to-earnings ratio (P/E) ratio can be used to calculate overvalued and undervalued stocks. This ratio can have multiple uses and is defined as the current stock price of a company divided by the company’s earnings per share (EPS) for the past twelve months. There are two types of P/E ratios which are trailing P/E and forward P/E. The former is based on historical results, while the latter is based on forecasted estimates. However, the P/E ratio is generally a type of valuation ratio.
Knowing a company’s historical earnings per share results would make it easier for investors to find an estimated price per share of a stock using the average price-to-earnings ratios from some comparable companies. An investor, looking at the actual P/E of a company would provide insight into how reasonable the stock of a company is when compared to its peers. Therefore, the ratio can tell if a stock is overvalued or undervalued as it tells investors if the stock price accurately reflects the company’s earnings potential or not.
So, if the P/E ratio of a company is low, there is a chance that investors are getting valuable stocks at a discounted price. This means that lower P/E indicates potential undervaluation if considerably lower than peers. Hence, suggests that a stock is undervalued or that the company is doing very well compared to its past trends. Conversely, the higher the P/E the more speculation is priced into the value, usually from bullish expectations of future potential. This indicates that investors in the public market are willing to pay more for every $1 of earnings the company produces, thus suggesting overvaluation.
How to find overvalued and undervalued stocks using the PEG ratio
Calculating the price-to-earnings growth ratio (PEG) can be used to find overvalued and undervalued stocks. This ratio is an extended analysis of P/E which is calculated as the stock’s P/E ratio divided by the growth rate of its earnings. The PEG ratio is an important ratio to many in the financial industry because it takes a company’s earnings growth into account, and tends to provide investors with a deeper insight into profitability growth compared to the P/E ratio.
For instance, a low P/E ratio may make a stock look like it’s worth buying, but when the growth rate is factored in, it might tell a different story. However, the lower the PEG ratio of a company, the more the stock may be undervalued given its earnings performance. More so, the extent to which a PEG ratio value indicates an overvalued or undervalued stock would vary by industry and by company type.
Generally, a PEG ratio of 1 or below one typically suggests that the stock is fairly priced or even undervalued, though this can vary by industry. Whereas, a PEG ratio above 1.0 suggests that the stock may be overvalued. Furthermore, the accuracy of this ratio depends on the accuracy and reliability of the inputs. It can be calculated with both trailing and forward growth rates which may differ substantially.
How to determine undervalued and overvalued stocks using the price-to-book (P/B)
The price to book (P/B) is another ratio used to determine undervalued and overvalued stocks. This ratio is calculated as the share price divided by the book value per share. Similar to the price-to-earnings ratio, the higher the price-to-book ratio, the more overvalued a stock’s price is. Conversely, a lower price-book ratio could indicate an undervalued stock, suggesting a greater potential for upside.
How to calculate overvalued and undervalued stocks using price-to-dividend ratio
The price-to-dividend ratio (P/D) is typically used to analyze if a dividend stock is overvalued or undervalued. This ratio shows how much investors are willing to pay for every $1 in dividend payments that the company pays out over twelve months. It is most useful in comparing a stock’s value against other dividend-paying stocks or against itself over time.
How to determine undervalued and overvalued stocks using the debt-to-equity ratio (D/E)
How to determine if a stock is overvalued or undervalued is to calculate the debt to equity ratio of the company. A high D/E ratio indicates that most of the company’s assets are financed through debt. Whereas, a low debt-equity ratio indicates that the company’s assets are primarily financed through equity.
A high debt-to-equity ratio compared to the average D/E ratio by industry indicates that the company is highly leveraged financially compared to its peers in the same industry. This could be seen as a strong sign that the company’s stock is overvalued. Whereas, a stock that is trading at a discounted price with a low debt to equity ratio tells us that the company’s stock price is undervalued as this company happens to be a very low-debt and financially sound company.
How to find overvalued and undervalued stocks using the return-on-equity ratio (ROE)
Calculating the company’s return-on-equity ratio (ROE) is one way to find overvalued and undervalued stocks. This ratio can be used to determine if a stock is overvalued or undervalued. The ROE measures a company’s profitability against its equity in percentage which is calculated by dividing the company’s net income by its shareholder equity.
This means that a low ROE indicates that the company generates very little returns from shareholder investment suggesting that the company’s stock is likely overvalued. Whereas, a high ROE could be an indication that a stock is undervalued because the company is making a lot of income compared to the amount of shareholder investment.
How to determine undervalued and overvalued stocks using the price-to-sales
The price-to-sales (P/S) ratio is popularly used to determine undervalued and overvalued stocks because most companies make sales. These sales made will also show some type of growth rate. The P/S ratio of a company is calculated by dividing the current stock price of the company by the 12-month sales per share. The sales per share metric are figured by dividing the company’s 12-month sales by the number of shares outstanding. Therefore, a low P/S ratio in comparison to its peers could indicate an undervalued stock while a high P/S ratio would indicate an overvalued stock.
How to calculate overvalued and undervalued using the enterprise value-to-sales
There are some companies that may not be publicly traded and do not have public share prices or public shares outstanding. In such cases, using enterprise value can be helpful to calculate overvalued and undervalued. The enterprise value gives you a view of the company’s capitalization which can be gauged with the stock price to know if it is under-priced or overpriced.
A company’s enterprise value is an alternative to market capitalization which is different from the market cap because it factors debt into the equation for determining a company’s valuation. For a non-public company, the enterprise value-to-sales (EV/S) is calculated by adding the shareholders’ equity and total debt minus cash. While the enterprise value for a public company is calculated by simply using the market cap plus the total debt minus cash.
How to find overvalued and undervalued stocks using EV-to-EBITDA
The EV-to-EBITDA is similar to EV/S but requires a company to have a reasonable level of operating income combined with depreciation and amortization. The EV is calculated as market cap plus total debt minus cash while the EBITDA is figured by adding depreciation and amortization to operating income. Many consider the EV to be a more accurate representation of a firm’s value. Therefore, the EV/EBITDA and other EBITDA multiples are usually used in merger and acquisition analysis.
In conclusion, the difference between overvalued and undervalued stocks meaning in business is that; overvalued stocks trade higher than their fair market value while undervalued stocks trade at a price that is significantly below their assumed intrinsic value.
In order to find whether a stock is overvalued or undervalued, it is important for investors to go through the annual reports, profit and loss accounts, or balance sheets of the underlying company. They should also look at any other development related to the company’s fundamentals or the sector in which it is carrying out operations.
Most importantly, it is best for investors planning to invest in overvalued and undervalued stocks to avoid companies with huge debt. More so, knowing about the company’s management and its background is also crucial as these have an impact on the price of a stock.