How to Tell If a Stock Is Overvalued/Undervalued
An overvalued or undervalued stock is one whose prevailing price in the securities market does not correspond to the profit projections or future revenue/earning estimates given by the company.
Many factors contribute to the inflation of stocks, key among them being trading hypnosis, whereby traders are sometimes willing to keep buying a stock even when it is apparent that its actual value is lower. Market fundamentals are also a leading cause of overvaluation or undervaluation of stocks.
What causes overvaluation and undervaluation?
Traders often interpret a sudden increase in the volume of traded stock to mean a looming upsurge in company returns. At times, this leads to a corresponding spike in demand for a stock, thereby driving prices up.
Economic impact on incomes
Booming economies often lead to increased earnings, which leads to increased spending. Nonetheless, it may take significantly longer for this to be felt by the stock market. This may result in undervaluation.
Conversely, recession leads to reduced earnings, but securities markets often lag in reflecting the resultant reduced expenditure. This can cause overvaluation.
Impact of news trends
Media coverage can be equated to free publicity for a company. When there's a sudden spike in positive mentions of a company in the media, the spotlight shifts to the company, and traders often react by buying more of the company's stock. This can cause overvaluation of a stock. Similarly, negative mentions, even when unfounded, may lead to a sudden loss of interest in a company’s stock, leading to undervaluation.
How can we tell if a stock is overvalued or undervalued?
For starters, the basic and most effective way to tell if the value reflected by the stock market is correct is by combining technical analysis and fundamental analysis of the concerned company.
The bottom line is that a stock's price should be within a reasonable margin of the actual market and industry performance. There are several tested and proven methods used by traders to know the true state of affairs when analyzing a stock. The key metrics are discussed below:
Price-to-sales (P/S) ratio is computed by first calculating a company's sales per share then dividing the prevailing stock price by the sales per share. The latter is calculated by dividing the reported sales figures in the past 12 months by the outstanding shares. If the P/S ratio turns out to be less than 1, then the stock is undervalued. If it's more than 4, then it is overvalued.
Price/Earnings to growth (PEG) ratio is simply the Price to Earnings ratio as a growth factor. It assesses the rate at which a company’s earnings have grown over a given period against its P/E ratio. It is, therefore, the P/E ratio divided by the annual rate of growth in earnings. Stock will be considered overvalued if the ratio exceeds one and undervalued if it is less than one.
Dividend yield evaluates a company's current position based on the dividends given to its shareholders. To calculate it, you have to divide the dividend earned for each share by the share price.
It is naturally expected that people will want companies that pay higher dividends. However, dividend yields of low-risk companies are generally lower than those of high-risk companies. Furthermore, dividend yields have an inverse relationship with valuation.
Return on equity (ROE) presents an evaluation of a company's income based on the investment pumped in by its shareholders. It is calculated by dividing net assets by the value of shares held by shareholders. Anything below 15% is generally considered an overvalued stock, but underlying factors such as recent mergers/acquisitions may cause variations in interpretation.
Comparing P/E Ratios. The P/E ratio tells us how much money a company generates for each share held as a ratio of the current stock price. This, therefore, means that if the P/E ratio rises, then the company is spending more to generate disproportionately less income — this explains why it is always a good idea to compare P/E ratios for companies operating within the same segment of the economy.
You may also need to check the average P/E ratio for that particular segment/industry before knowing whether a company's valuation is correct. If companies X and Z are both in the software business, and X has a P/E ratio of 25 and Z has 10, then it is very likely that company X is overvalued, relative to Z. The inverse is true for undervaluation.
However, it is always important to understand the factors behind a company's high or low P/E before making an investment decision. This is because factors such as failed acquisition and other fundamentals may cause short-term effects on the stock price, but the company may turn around its fortunes in the next cycle.
The role played by value traps
Still, with P/E ratios, certain sectors enjoy cyclic changes in fortunes based on many market fundamentals. For example, an events company may project a low P/E ratio due to a forthcoming major event such as the Olympics. This may make the company an endearing investment in the few years or months leading to the event.
However, closer scrutiny of the company's actual earnings after the event may reveal that it was actually overvalued due to the hype around the Olympics. This is an example of a typical value trap that smart investors should be keen to avoid.
While making short-term investments for profit is not a bad idea, you must be keen to exit when your position is still profitable.
Some companies also get undervalued due to the seasonal changes in economic activity. For example, many airlines may be undervalued as a result of the prevailing impacts of covid-19 on global travel.
Knowing the true value of a company is key if you are to succeed as an investor. It helps you to know exactly what you are getting into and enables you to evaluate the risks taken and possible profit margins.
However, you should not only rely only on valuation when investing. You should inquire about the reasons behind specific valuation and know whether or not those figures will hold under pressure.