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 priceto drop eventually.
Key Takeaways:
- 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 unjustifiably and significantly in excess of its peers.
- Overvalued stocks are sought by investors looking to short positions and capitalize on anticipated price declines.
Overvaluation may result from an uptick inemotional 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 valuation metric for publicly traded companies is the P/E ratio, which analyzes a company's stock price relative to its earnings. An overvalued company trades at an unjustifiably rich level compared to its peers.
Understanding Overvalued Stocks
A small group ofmarket theorists believes that the market is perfectly efficient, by nature. They opine that fundamental analysis of a stock is a pointless exercisebecause 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 stocksbecause the market is as irrational as its participants.
Overvalued stocks are ideal for investors looking to short a position. This entails selling shares to capitalize on an anticipated price declines. 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 stock price relative to its earnings.
Analysts looking for stocks to short may seek overvalued companies with high P/E ratios, particularlywhen compared toother companies in the same sector or peer group. For example, assume a company hasa stock price of $100and 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 banner year and makes $10 in EPS, the new P/E ratio is $100 divided by $10, or 10 times ($100/$10 = 10). Most people would consider the company to be overvalued at a P/E of 50, but possibly undervalued at 10.
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.
FAQs
An overvalued stock occurs when its market price exceeds its intrinsic value. Strategies for managing overvalued stocks include selling or reducing holdings, setting stop-loss orders, diversifying your portfolio, conducting fundamental and technical analyses, and considering shorting for experienced investors.
What does overvalued mean in stocks? ›
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 unjustifiably and significantly in excess of its peers.
What is an example of an overvalued asset? ›
An overvalued asset is an investment that trades for more than its intrinsic value. For example, if a company with an intrinsic value of $7 per share trades at a market value $13 per share, it is considered overvalued.
What is an example of overvaluation of closing stock? ›
For example, the actual value of closing stock of previous year is Rs. 20000 overvalued at Rs 70000, the value of credit side total will increase and the gross profit will increase. For the current year previous year closing stock is the opening stock and is debited in the trading account.
What happens if you buy an overvalued stock? ›
If you buy an overvalued stock, it will likely end up underperforming the market as the price eventually falls back to its real value.
What does overvalued mean in simple terms? ›
: to value too highly : place too much importance on. overvalued his contribution to the group's effort.
How to see if a stock is overvalued? ›
This ratio is used to assess the current market price against the company's book value (total assets minus liabilities, divided by number of shares issued). To calculate it, divide the market price per share by the book value per share. A stock could be overvalued if the P/B ratio is higher than 1.
Do you sell overvalued stock? ›
By the same token, though, holding on to a company that is overvalued is a risk. In these situations, it's typically best to sell your stock and be happy with the profits you've made no matter what the stock does in the future.
What if opening stock is overvalued? ›
In the case of overvalued shares, dividend disbursem*nts 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.
What is an example of an overvalued exchange rate? ›
For example, if the U.S. dollar is overvalued with respect to the peso, then a U.S. tourist traveling to Mexico will be very happy. In fact, the more overvalued the dollar is, the better. However, for an exporter of U.S. goods to Mexico, its price in peso terms will be higher the more overvalued is the dollar.
Most overvalued US stocks
| Symbol | RSI (14) | Price |
|---|
| LLGVN D | 78.99 | 3.19 USD |
| ADMA D | 78.92 | 10.63 USD |
| VIRC D | 78.68 | 17.48 USD |
| DDYCQ D | 78.63 | 10.20 USD |
29 more rowsThe intrinsic value of one COST stock under the Base Case scenario is 426.85 USD. Compared to the current market price of 851.21 USD, Costco Wholesale Corp is Overvalued by 50%.
Is Apple overvalued? ›
With its 3-star rating, we believe Apple's stock is fairly valued compared with our long-term fair value estimate of $160 per share. Our valuation implies a fiscal 2024 adjusted price/earnings multiple of 25 times, a fiscal 2024 enterprise value/sales multiple of 7 times, and a fiscal 2024 free cash flow yield of 4%.
Should you buy or sell an overvalued stock? ›
By the same token, though, holding on to a company that is overvalued is a risk. In these situations, it's typically best to sell your stock and be happy with the profits you've made no matter what the stock does in the future.
How do you deal with overvalued stocks? ›
An overvalued stock occurs when its market price exceeds its intrinsic value. Strategies for managing overvalued stocks include selling or reducing holdings, setting stop-loss orders, diversifying your portfolio, conducting fundamental and technical analyses, and considering shorting for experienced investors.
Is it good to buy undervalued stocks? ›
Advantages of Undervalued Stock
It presents an opportunity to purchase shares at low prices from well-established or promising companies. These stocks also feature low risk due to the fact that such undervaluation is cyclical and the company has the potential to attain its intrinsic value.
