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.
FAQs
An overvalued stock occurs when its market price exceeds its intrinsic value. Strategies for managing overvalued stocks include selling or reducing holdings, setting stop-loss orders, diversifying your portfolio, conducting fundamental and technical analyses, and considering shorting for experienced investors.
What is an example of overvalued? ›
An overvalued asset is an investment that trades for more than its intrinsic value. For example, if a company with an intrinsic value of $7 per share trades at a market value $13 per share, it is considered overvalued.
What does overvalued mean in stocks? ›
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 price to drop eventually.
Is it good to invest in overvalued stock? ›
Disadvantages of Overvalued Shares
Being caught in a value trap, by which an investor might incur considerable losses. The requirement of market proficiency to determine whether a stock is overvalued or not.
How to trade overvalued stocks? ›
Apart from short selling, investors can also trade overvalued stocks by using options – specifically, put options. Options are derivatives, which means that they are complex financial instruments and that their worth is based upon the worth of an underlying asset – in this case, a stock.
What is an example of an overvalued asset? ›
Overvalued Asset Definition
Put another way, it's an asset whose current price is not matched by its earnings outlook (profit projections). This is easy to understand in action. If a stock's intrinsic value is $10 and it's currently trading for $20, that stock is overvalued.
What does overvalued mean in simple terms? ›
: to value too highly : place too much importance on. overvalued his contribution to the group's effort.
How do I know if a stock is overvalued? ›
This ratio is used to assess the current market price against the company's book value (total assets minus liabilities, divided by number of shares issued). To calculate it, divide the market price per share by the book value per share. A stock could be overvalued if the P/B ratio is higher than 1.
Is Amazon stock overvalued? ›
With its 3-star rating, we believe Amazon's stock is fairly valued compared with our long-term fair value estimate. Over the long term, we expect e-commerce to continue to take share from brick-and-mortar retailers.
What are the most overvalued stocks? ›
Most overvalued US stocks
| Symbol | RSI (14) | Price |
|---|
| FEXD D | 95.06 | 11.60 USD |
| LABP D | 90.94 | 22.48 USD |
| MCAC D | 88.69 | 11.24 USD |
| INAQ D | 87.03 | 11.19 USD |
29 more rowsBy comparison, Li Auto's forward earnings metrics are 15.1x for 2024, 11.3x for 2025, and 8.9x in 2026 — much more attractive. Equally, the all-important price-to-earnings-to-growth (PEG) ratio is 3.6 for TSLA. This is by no means an enticing ratio, and it infers that Tesla stock is overvalued considerably.
Is Apple overvalued? ›
With its 3-star rating, we believe Apple's stock is fairly valued compared with our long-term fair value estimate of $160 per share. Our valuation implies a fiscal 2024 adjusted price/earnings multiple of 25 times, a fiscal 2024 enterprise value/sales multiple of 7 times, and a fiscal 2024 free cash flow yield of 4%.
Is it better to be overvalued or undervalued? ›
Generally, undervalued shares are favored over overvalued ones, as the investors buy low and sell high. If the company is performing well, it can give promising returns. Buying an overvalued share doesn't have this advantage, as the price returns to its intrinsic value, which is lower.
What is the undervalued stock strategy? ›
Finding undervalued stocks isn't just about finding cheap stocks. The key is to look for quality stocks at prices under their fair values, rather than useless stocks at a very low price. The difference is that good quality stocks will rise in value over the long term.
Should you short overvalued stocks? ›
“If a stock is overpriced, it's a good thing if short sellers can bring the price back down to its true value.”
Do you buy or sell an overvalued stock? ›
By the same token, though, holding on to a company that is overvalued is a risk. In these situations, it's typically best to sell your stock and be happy with the profits you've made no matter what the stock does in the future.
How do you know if something is overvalued? ›
Price-earnings ratio (P/E)
A high P/E ratio could mean the stocks are overvalued. Therefore, it could be useful to compare competitor companies' P/E ratios to find out if the stocks you're looking to trade are overvalued. P/E ratio is calculated by dividing the market value per share by the earnings per share (EPS).
What is an example of an overvalued idea vs delusion? ›
An example of how an over-valued idea fits with the European description is in anorexia nervosa in which an underweight individual may believe she is too fat. Such patients may hold such beliefs with extreme tenacity but they are not considered delusional.
What is an example of an overvalued exchange rate? ›
Examples of Overvalued Exchange Rates
It makes it more difficult to export goods and can lead to lower growth. For an economy like Japan which relies on a strong export sector, this decline in competitiveness could be damaging to their economy.
What is an example of undervalued? ›
An undervalued stock is defined as a stock that is selling at a price significantly below what is assumed to be its intrinsic value. For example, if a stock is selling for $50, but it is worth $100 based on predictable future cash flows, then it is an undervalued stock.
