An overvalued stock has a price higher than its earnings outlook, and profit projections. It is also compared to its price-earnings (P/E) ratio. Analysts and other economic experts, therefore, expect the price to drop eventually. Investors take a keen interest in judging the valuations of a stock.
Overvaluation can result from irrational, illogical and emotional trading. It can also occur due to deterioration in a company’s fundamentals or financial strength.
Knowing whether the stock is overvalued or not helps investors take their investment decisions and stop paying more for a weak stock.
What are overvalued stocks?
There are two kinds of market theories: one that believes that the market is very efficient and there are no undervalued or overvalued stocks. They don’t believe in the fundamental analysis of a stock and believe that the market is all-knowing. The second theory is that there are always opportunities to look at undervalued Contrarily, fundamental analysts are firm in their belief that there are always opportunities to dig out undervalued and overvalued stocks because the market is irrational. Overvalued stocks are good for investors looking to short a position. This means selling shares when the stocks fall as per anticipation due to their overvaluation.
Are overvalued stocks good or bad?
An overvalued stock will experience a price fall at some time or the other and return to a level which reflects its level and fundamentals. In that sense, it is bad for regular investors as they try not to buy annualised overvalued stocks. However, in some cases, investors may prefer some of the overvalued stocks due to their superior management, brand, and other factors.
How to find overvalued stocks
There is a metric to find out if the stock is overvalued. It is called the Relative earnings analysis. It is the most common way to find out if the stock is overvalued. This compares earnings to some other value such as price. The most popular and easy way to compare is P/E ratio, which analysis stock price relative to the company’s earnings.
For example, if a company has a stock price of NZ$ 100 and earnings per share of NZ$2, the P/E ratio can be assessed by dividing the price of the share by earnings per share. In this case you get 50, which means the stock is trading 50 times the earnings. This is a grossly overvalued stock.
Investors who are short-seller can look for overvalued companies with high P/E ratios, as compared to other companies in the same sector also called the peer group.
A share can be overvalued in two ways. Firstly, due to a sudden rise in demand, or due to an investor’s perception. This can be manipulated and perception can be created. And if the rise in price is not justified, then the stock could be overvalued. The second way is when the revenue, earnings, and the balance sheet of a company declines, but the price remains the same, then the stock can be said to be overvalued.
Overvalued and undervalued are opposite of each other and denote the stock’s pricing in comparison to its earnings. When a stock is low priced as compared to its earnings, it’s called undervalued. The price of the stock is also judged in comparison to growth potential, financial status and earnings projections.
Why overvalued stocks matter
Investors usually try to avoid an overvalued stock as it has to come down to match to a level which reflects its financial status and fundamentals. It is generally seen that a stock that is overvalued is likely to fall and return to its own levels. Investors avoid overvalued stocks as they lose money when they fall.
A fully valued stock reflects the full and correct value of a stock. In this, the market recognises the fair price and the company’s underlying fundamental earnings power which makes the share steady. It can neither fall too much nor gain too much. If a stock goes down from its fair value, it is considered overvalued, and if it goes down, it is considered undervalued.
Fully Valued vs. Overvalued or Undervalued
Overvalued stocks and undervalued stocks can be contrasted with fully valued ones.
An undervalued stock is the one that sells at a significantly lower price than its actual value and can whose price is expected to rise to match its intrinsic value. This is opposite to an overvalued stock whose price is supposed to fall to match its actual and fair value.
Traders often seek undervalued stocks so that they can be brought back to their full value, thus giving significant gains to the traders. In the same way, overvalued shares may be short sellers, gaining when they are brought to their fair value.