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 priceto drop eventually.
Key Takeaways:
- An overvalued stock has a current price that is not justified by its earnings outlook, typically assessed by its P/E ratio.
- A company is considered overvalued if it trades at a rate that is unjustifiably and significantly in excess of its peers.
- Overvalued stocks are sought by investors looking to short positions and capitalize on anticipated price declines.
Overvaluation may result from an uptick inemotional trading, or illogical, gut-driven decision making that artificially inflates the stock's market price. Overvaluation can also occur due to deterioration in a company's fundamentals and financial strength. Potential investors strive to avoid overpaying for stocks.
The most popular valuation metric for publicly traded companies is the P/E ratio, which analyzes a company's stock price relative to its earnings. An overvalued company trades at an unjustifiably rich level compared to its peers.
Understanding Overvalued Stocks
A small group ofmarket theorists believes that the market is perfectly efficient, by nature. They opine that fundamental analysis of a stock is a pointless exercisebecause 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 stocksbecause the market is as irrational as its participants.
Overvalued stocks are ideal for investors looking to short a position. This entails selling shares to capitalize on an anticipated price declines. 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 analyzes a company's stock price relative to its earnings.
Analysts looking for stocks to short may seek overvalued companies with high P/E ratios, particularlywhen compared toother companies in the same sector or peer group. For example, assume a company hasa stock price of $100and earnings per share of $2. The calculation of its P/E ratio is determined by 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 banner year and makes $10 in EPS, the new P/E ratio is $100 divided by $10, or 10 times ($100/$10 = 10). Most people would consider the company to be overvalued at a P/E of 50, but possibly undervalued at 10.
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 the pharma giant Ely Lilly to be overvalued because the company's valuation reached "untenable levels following the company's meteoric rise during the tail end of 2019 and early days of 2020."
According to The Motley Fool, in January 2020, the company's stock was the second most expensive among its industry peers and Eli Lilly might find it hard to deliver consistent expected growth.
