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 price to drop eventually.
Overvaluation may result from an uptick in emotional trading, or illogical, gut-driven decision-making, that artificially inflates the stock's market price, or from deterioration in a company's fundamentals and financial strength. Potential investors strive to avoid overpaying for stocks.
The Theory Behind 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 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 stocks because the market is as irrational as its participants.
Overvalued stocks are ideal for investors looking to short a position, shorting entails selling shares with the intention of repurchasing them when the price falls back in line with the market. 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 analyses a company's earnings to its stock price. An overvalued company would be one trading at a rate that’s 50 times earnings.
Analysts looking for stocks to short may 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 from 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 bumper year and makes $10 in EPS, the new P/E ratio is $100 divided by $10, or 10 times ($100/$10 = 10). Experts consider the company overvalued if earnings are $2 per share, but undervalued if earnings are $10 per share.
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 electric carmaker Tesla to be vastly overvalued, because of annual net losses that routinely break the $100 million mark. Nevertheless, investors tend to be drawn to the company, because of its alluring vehicles and its tech-forward story.