What Is 'Overvalued'?
Let me explain what an overvalued stock really means. It's when a stock's current price isn't backed up by its earnings outlook—those are the profit projections—or its price-to-earnings (P/E) ratio. As a result, analysts and economic experts like me anticipate that the price will eventually fall.
Key Takeaways
Here's what you need to know directly: An overvalued stock has a price that doesn't match its earnings outlook, usually judged by the P/E ratio. A company becomes overvalued if it's trading way above its peers without good reason. Investors who spot these often look to short them, betting on the price drop to make a profit.
Overvaluation can come from emotional trading spikes or just poor decision-making that pumps up the market price artificially. It might also happen if the company's fundamentals and financial health start to weaken. As a potential investor, you should aim to avoid paying too much for stocks like these.
Fast Fact
The go-to valuation metric for public companies is the P/E ratio, which looks at the stock price against its earnings. If a company is overvalued, it's trading at a level that's too high compared to similar companies.
Understanding Overvalued Stocks
Some market theorists claim the market is perfectly efficient, meaning fundamental analysis is useless because the market knows everything. In their view, stocks can't truly be undervalued or overvalued. But I side with fundamental analysts who believe the market is as irrational as the people in it, so there are always chances to find undervalued or overvalued stocks.
These overvalued stocks are perfect for investors wanting to short a position—selling shares to profit when the price falls as expected. Sometimes, though, stocks trade at a premium legitimately because of strong branding, great management, or other factors that boost one company's earnings value over another's.
How to Find Overvalued Stocks
The main way to spot an overvalued stock is through relative earnings analysis, comparing earnings to something like price. The P/E ratio is the most common here, checking the stock price against earnings.
If you're an analyst hunting for shorts, look for companies with high P/E ratios, especially versus their sector or peers. Take this example: A company with a $100 stock price and $2 earnings per share has a P/E of 50 ($100/$2 = 50). That's trading at 50 times earnings.
Now, if that company has a great year and hits $10 in EPS, the P/E drops to 10 ($100/$10 = 10). Most would say it's overvalued at 50 but possibly undervalued at 10.
Real World Example
Remember, overvaluation is often just an analyst's opinion, but sites like The Motley Fool don't hold back. They called pharma giant Eli Lilly overvalued after its stock skyrocketed in late 2019 and early 2020, pushing its valuation to unsustainable levels.
In January 2020, Eli Lilly's stock was the second priciest among industry peers, and The Motley Fool noted it might struggle to keep up the expected growth.
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