What is an Overvalued Stock?
An overvalued stock has a current price that isn’t justified by its earnings outlook, commonly evaluated using the price-earnings (P/E) ratio. Analysts and financial experts typically expect such stocks to experience a price drop eventually.
Key Takeaways
-
Earnings Outlook: An overvalued stock’s current price is unfounded when comparing its earnings prospects, usually using the P/E ratio.
-
Price Comparison: A stock is overvalued if it trades at a significantly higher rate than its peers, without justifiable reasons.
-
Trading Strategy: Overvalued stocks appeal to investors looking to short sell and capitalize on the expected price decline.
Overvaluation may arise from emotional trading decisions that inflate the stock’s market price unnaturally. It can also occur due to declining company fundamentals. Investors typically aim to avoid overpaying for such stocks. The P/E ratio is the most widely used metric for evaluating the valuation of publicly traded companies.
Understanding Overvalued Stocks
Some market theorists argue that markets are perfectly efficient and that fundamental analysis of stocks is futile. They believe the market is exhaustive in its pricing. Conversely, many fundamental analysts believe there are always opportunities to discover undervalued and overvalued stocks because market participants often act irrationally.
Overvalued stocks are particularly appealing for investors aiming to short sell. This involves selling shares in anticipation of a price drop, thereby making a profit when the stocks are repurchased at a lower price. Investors might also trade overvalued stocks at a premium for various reasons, including the company’s brand, management quality, or other factors that justify a higher valuation relative to peers.
How to Find Overvalued Stocks
The most common method for identifying overvalued stocks is relative earnings analysis, typically through the P/E ratio, which compares a company’s stock price to its earnings. Analysts look for companies with high P/E ratios compared to others within the same sector or peer group.
Example of Identifying Overvaluation
For instance, assume a company has a stock price of $100 and earnings per share (EPS) of $2, resulting in a P/E ratio of 50 ($100/$2 = 50). If the same company’s EPS rises to $10, the new P/E ratio would be 10 ($100/$10 = 10). While a P/E of 50 would suggest the stock is overvalued, a P/E of 10 might indicate undervaluation.
Real World Example of Overvaluation
Though a stock being overvalued often remains a matter of opinion, some analysts’ observations can be insightful. For example, financial analysts at The Motley Fool determined that the pharmaceutical giant Ely Lilly’s stock was overvalued in January 2020. They noted that at that time, the company’s valuation had reached exceptionally high levels following significant growth in late 2019 and early 2020. Furthermore, Ely Lilly’s stock was the second most expensive among its industry peers, raising concerns about sustaining such growth future.
Related Terms: Market Price, Earnings, Short Selling, Efficient Market Hypothesis, Relative Earnings Analysis.
