An overvalued stock has a current price that is not justified by its earnings outlook or price/earnings (P/E) ratio, so it is expected to drop in price. Overvaluation may result from an emotional buying spurt, 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 staunch efficient market theorists believe the market is perfectly efficient. They believe that fundamental analysis of a stock is a wasted exercise because the stock market is all-knowing; as such, stocks are never undervalued or overvalued.
Fundamental analysts think otherwise. For them, 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: stocks that are undervalued and stocks that are overvalued. Undervalued stocks are offered to investors at a discount, but overvalued stocks are trading at a premium. Overvalued stocks are ideal for investors looking to short a position; that is, selling shares with the intention of buying them when the price is in line with the market. Overvalued stocks may also be legitimately trading at a premium due to brand, goodwill, better management or other factors that increase the value of one company's earnings over another.
The most common way to determine if a stock is overvalued uses relative earnings. Relative earnings 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. A company that's trading at a price 50 times its earnings is considered to be 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 most likely to be overvalued.
Analysts looking for stocks to short are looking for overvalued companies with high P/E ratios, especially when compared against other companies in the same industry or peer group. For example, assume a company with a stock price of $100, and an earnings per share (EPS) of $2, has a P/E ratio, calculated as price divided by earnings, of $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. The company is considered to be overvalued if earnings are $2 per share, but undervalued if earnings are $10 per share.