An overvalued stock has a current price that is not justified by its earnings outlook or price-earnings (P/E) ratio; therefore, the price is expected to drop. Overvaluation may result from an uptick in emotional, 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 that the market is perfectly efficient. They believe that 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: stocks that are undervalued and stocks that are overvalued. Undervalued stocks are offered to investors at a discount, but overvalued stocks are traded 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 traded at a premium due to the 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 analysis. 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. 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 likely to be 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 (EPS) 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. The company is considered to be overvalued if earnings are $2 per share but undervalued if earnings are $10 per share.