Overvalued
What Is "Overvalued"?
An overvalued stock has a current price that isn't justified by its earnings outlook, known as profit projections, or its price-earnings (P/E) ratio. Consequently, analysts and other economic experts expect the price to eventually drop.
Overvaluation might result from an uptick in emotional trading, or silly, stomach driven decision making that misleadingly inflates the stock's market price. Overvaluation can likewise happen due to deterioration in a company's fundamentals and financial strength. Potential investors strive to try not to overpay 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 outlandishly rich level compared to its peers.
Understanding Overvalued Stocks
A small group of market theorists believes that the market is perfectly efficient, by nature. They opine that fundamental analysis of a stock is a pointless exercise because the stock market is infinitely knowledgeable. Therefore, stocks may neither be genuinely undervalued or overvalued. Conversely, fundamental analysts are ardent in their belief that there are consistently opportunities to ferret out undervalued and overvalued stocks because the market is pretty much 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 likewise 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.
The most effective method to Find Overvalued Stocks
Relative earnings analysis is the most common method for identifying an overvalued stock. This metric compares earnings to some comparable market value, like price. The most popular comparison is the P/E ratio, which analyzes a company's stock price relative to its earnings.
Analysts searching for stocks to short might seek overvalued companies with high P/E ratios, particularly when compared to other companies in the same sector or peer group. For example, assume a company has a stock price of $100 and earnings per share of $2. The calculation of its P/E ratio is determined by separating the price by the earnings ($100/$2 = 50). Thus, in this example, the security is trading at 50 times earnings.
In the event that 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). The vast majority would consider the company to be overvalued at a P/E of 50, yet possibly undervalued at 10.
Real World Example
In spite of the fact that by definition, a stock is overvalued exclusively by the opinion of an analyst, The Motley Fool website is never modest about weighing in. For example, they deemed the pharma goliath 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 long periods of 2020."
As per The Motley Fool, in January 2020, the company's stock was the second generally expensive among its industry peers and Eli Lilly could find it hard to deliver consistent expected growth.
Highlights
- An overvalued stock has a current price that isn't justified by its earnings outlook, typically assessed by its P/E ratio.
- Overvalued stocks are looked for by investors hoping to short positions and capitalize on anticipated price declines.
- A company is considered overvalued in the event that it trades at a rate that is ridiculously and fundamentally in excess of its peers.
