An overvalued stock has a current price that is not justified by its earnings outlook or price-earnings (P/E) ratio; therefore, experts expect the price to drop. Overvaluation may result from an uptick in emotional trading, which inflates the stock's market price, or from a deterioration in a company's financial strength. Potential investors do not want to overpay for a stock.
A small group of market theorists believe the market is perfectly efficient. They believe fundamental analysis of a stock is pointless because the stock market is all-knowing and stocks are never undervalued or overvalued.
Fundamental analysts think otherwise. These analysts consider that there are always opportunities to find undervalued and overvalued stocks because the market is as irrational as its participants.
Fundamental analysts look for two conditions in stock market analysis: undervalued and overvalued stocks. Investors can purchase undervalued stocks at a discount, but there is a premium on trading overvalued stocks. Overvalued stocks are ideal for investors looking to short a position, which is selling shares with the intention of buying them when the price is in line with the market. Investors may also legitimately trade overvalued stocks at a premium due to the brand, goodwill, better management or other factors that increase the value of one company's earnings over another.
Relative earnings analysis is the most common way to determine an overvalued stock. This analysis involves comparing earnings to some market value, such as price. The most popular ratio is the P/E ratio, which compares a company's earnings to its stock price. Experts consider a company that's trading at a price 50 times its earnings is trading at a much higher multiple than a company trading for 10 times its earnings. In fact, the company trading for 50 times its earnings is likely overvalued.
Analysts looking for stocks to short are looking for overvalued companies with high P/E ratios, particularly when compared to other companies in the same industry or peer group. For example, assume a company has a stock price of $100 and an earnings per share of $2. Its P/E ratio is calculated as price divided by earnings, which is $100 divided by $2, or 50 times. 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. Experts consider the company overvalued if earnings are $2 per share but undervalued if earnings are $10 per share.