How to Tell if a Stock Is Overvalued or Undervalued
Overvalued or Undervalued Stock?
When it comes to investing, there is a lot to consider, such as an investment strategy and which sectors you want exposure to. In fact, it only takes a few major decisions to determine the overall success of your investment portfolio. One major key driver for successful investing over the long-term is determining if a stock is overvalued or undervalued before buying or selling. This article will go through how to determine if a stock is overvalued or undervalued so you can apply the knowledge to your own investment portfolio.
The answer is not simply looking at a stock chart and seeing how a company’s stock has performed over a certain period. If a stock is down over time, it does not mean the stock is undervalued, but requires a little bit more research. There is no need to be overwhelmed; you don’t need an MBA or Ph.d to determine if a stock is overvalued or undervalued.
There are times a stock could be trading at a multi-year low and actually be overvalued, while the opposite–being undervalued while trading at an all-time high—could occur as well.
An overvalued stock is one that is currently trading at a valuation that is too high, considering the company’s fundamentals. This occurs because investors bid up the stock price based on future assumptions for the stock and/or sector. Catalysts for these assumptions include new products, projected growth. and hype surrounding the sector.
Any good news from the company would either keep the valuation high or even cause it to trade at a higher valuation–which, for investors, means more risk. With any bad news, there is a higher probability of seeing a price decline, and the valuation could fall and be in line with what investors would want to own the stock at. There could also be a lot of volatility seen from the investment, and knowing if the stock is overvalued could prepare you well to stomach it.
An undervalued stock is the opposite, trading too low when compared to its earnings outlook, growth projections, and financial status. At times, a stock may be undervalued because investors are ignoring the name or segment or simply don’t want exposure to the sector.
Negative news regarding an undervalued stock could cause it to become even more undervalued, if not stay around the same range. Good news, on the other hand, should raise valuation. The goal of this strategy is to generate positive returns and minimize risk.
How to Determine If a Stock Is Overvalued or Undervalued
1. Determine What You Want to Own
Before looking at the financials of a company, determine a stock or sector that you are looking to get exposure to. Decide your comfort level in terms of company size, be small-cap, mid-cap, or large-cap. Also choose if you would like to receive a dividend for your time in the investment.
Answering these questions will save a lot of time and allow you to focus solely on companies that would meet your criteria.
2. Use the Equation
Once you know the stock or sector that you are looking to invest into, there are a few financial metrics to apply.
To determine if a stock is overvalued or undervalued, use the following formula:
PEG = Price/Earnings ÷ Growth of Earnings
This formula is for the price-to-earnings (PEG) ratio of a security. The initial part of the PEG ratio is the price-to-earnings (P/E) ratio of a company, which calculated by taking the current trading price and dividing it by the company’s annual earnings per share.
The latter part of the ratio is determined by looking at the company’s earnings growth. This is by taking a view of the expectations of analysts that follow the company closely. This number would be in the format of a percentage.
A PEG ratio greater than 1.0 means that the stock is overvalued, while below 1.0 means is is undervalued. When the PEG ratio is exactly 1.0, then the stock is trading at fair valuation.
How to Calculate the Value of Stock
Below is a chart of three stocks: one overvalued, one fair value, and one undervalued. Again, these classifications are based on their PEG ratios.
|Stock||PEG Ratio||Price-to-Earnings (P/E) Ratio||Expected Earnings Growth|
Now, when looking at the above chart and the P/E ratios, many investors may conclude that stock A is undervalued. However, the true undervalued stock of the three is C. Let me explain.
PEG Ratio (Stock A): 20 ÷ 11 = 1.81
The result is greater than one, so stock A is overvalued, as explained above. The markets are expecting a very high growth rate from the stock, with the high valuation coming from investors bidding up the shares higher, with the P/E ratio failing to support the growth. The future growth of the company is less than both stocks B and C.
PEG Ratio (Stock B): 25 ÷ 25 = 1.0
This PEG ratio is 1.0, so stock B is trading at a fair valuation.
PEG Ratio (Stock C): 40 ÷ 50 = 0.8
Even though the P/E ratio for stock C is high, the future growth rate is higher to support the high ratio. Based on the PEG ratio, the stock is actually trading as undervalued.
How to Determine a Stock’s Value Based on Management
A few actions taken by a company will signal to the markets that management believes the current share price is undervalued.
One would be having a share repurchase program in place. By buying back its own shares using earnings and reducing the number of outstanding shares available on the overall markets, management makes what they believe to be the best use of capital.
Another sign to the markets of a stock being undervalued is when the senior managers of a company use their own money to buy shares in their own business. This is known as insider buying and is done only because those manages believe the shares will eventually be trading higher.
This also aligns management’s team goals with shareholders’ personal interests as they will work harder to ensure the business’ success, as the insiders won’t want to lose money on their own investments. This move is a positive because insiders have data on the business which is not available to all investors.
There are also times when a company’s administration will take advantage of a stock trading at an overvalued price. Rather than come out and say the shares are overvalued, these individuals will instead issue more shares in the market. This move shows that management believes the shares are overvalued and is the opposite of share repurchases, resulting in more shares available in the marketplace. This will dilute the current shareholders and future investors looking to own shares.
A management team does this to take advantage of the overvaluation of the stock so more money can be raised through an equity sale. Depending on the company’s financials, the money may be used for operating costs or to acquire another business in its sector.
This could be dangerous, because the whole sector could be overvalued, meaning one overvalued company would be purchasing another. There would need to be a perfect plan and execution from the company to ensure the valuation stays high.
Other Important Factors to Think About
1. Are Earnings Steady or Volatile?
Once you have decided which stock or sector to invest into, there is still more to determine regarding the company’s valuation.
For one, determine if the company is cyclical or non-cyclical. A cyclical company is one that sees positive results based on a booming economy, so take a look at the current economic environment; if the economy starts to turn negative, then the stock could become overvalued. But if the economy is turning a corner, the stock could be undervalued since investors have stayed away from the sector.
An example would be stocks that depend on earnings from a commodity. If the commodity continues to see more upside, the stock should as well. However, because of the strong correlation to the commodity, there could be a downdrift in the price and the stock price should follow.
Therefore, determining if the stock is overvalued or undervalued may not prove useful. In this case, more research would be required, particularly for info such as the economy outlook and the commodity price outlook.
A non-cyclical company is one that sees growth no matter how the economy is performing, as the products are needed by consumers every day. Therefore, there would be less of a need to research outside of the company.
2. Would You Want to Get Paid?
If you’re looking to receive income in a form of a dividend, determine if you want to own a high-dividend-yielding stock, a steady dividend payer, or one that grows over time.
This choice will be based on your own personal goals when deciding to make an investment into a company. Once you’ve decided which type of dividend stock you want to own, take a look at the history of the company’s dividend payout. This will give you a clue about how the future dividend will look like. For instance, a company that has a long track record of increasing its dividend will most likely continue this pattern.
3. Ensure the Company Is Not Financially Leveraged
Before investing in a stock, it is important to look at the debt picture of the company. Even if a business has a high growth rate, the balance sheet may have a lot of debt. If everything does not go as planned for the company, there will be still be obligations to pay back the debt. This could result in a change of business plan to restructure the company’s financials. Also keep in mind that investors would be faced with their initial investment now being based on different goals than those of the company.
Also consider the debt-to-capital ratio, calculated by taking the company’s debt and dividing it by the total capital. When the ratio is above 50%, it means the debt load is heavy and being used to grow the business. A ratio below 50% means the debt is in control and being using strategically, with the business still growing organically.
The Bottom Line on Overvalued or Undervalued Stocks
If you are looking to buy or sell a stock, it is still important to view the business’ quarterly results. Also take the time to consider the viewpoint of management regarding the current and future business environments. This could have a big impact your on your overall return.
If you happen to already own shares of a company, it is important to regularly use the PEG ratio, because even though you may have purchased the shares at a discount, they could become overvalued, with other stocks in the same sector now looking more appealing.