Every investor looks for the intrinsic value of the stock to know if it is overvalued or undervalued. The intrinsic value of the stock is the perceived valuation which may be different from the current market price. This value is what the asset is worth, and it is calculated taking various factors into account. An overvalued stock is when the share trades at a higher value than the intrinsic price. It is essential to learn how to know if a stock is overvalued as it would help you avoid losses on the investment.

What is an overvaluation of a stock price?

A stock is overvalued when its current market price is not justified by its profit projections or earnings outlook. A stock’s value can be inflated by emotional or illogical trading, a decline in the company’s financial strength or fundamentals. Some of the reasons for stocks getting overvalued are mentioned below:

Rise in demand – There may be a sudden spurt in buying of company stock. The rise in trading volume may drive prices higher than the fair price.   

Change in earnings – When the economy tanks and there is the impact on public spending, a company’s profits could drop. However, the stock price sometimes does not fall to reflect the new earnings level. This could result in the stock’s overvaluation.

Cyclical fluctuations – Some companies perform better during certain cycles. This could have an impact on the stock price.

News coverage – A sudden surge in positive news coverage could lead to a rise in the stock purchase of a company. This can overvalue the stock.

How to know if a stock is overvalued?

Traders use technical and fundamental analysis to know if a stock is overvalued. One of the most common ways of identifying overvalued stock is by relative earnings analysis. Some of the ways to check if your stock is overvalued are:

1. Price-earnings ratio

2. EV/ EBITDA ratio

3. Price to sales ratio

4. Price to dividend ratio

5. Price/ Earnings to growth ratio

6. Dividend yield

7. Return on equity

Price to earnings ratio – The price to earnings ratio is calculated by dividing the current share price by the earnings per share (EPS). This ratio reveals how much an investor is willing to pay per rupee of earnings. For example, if the P/E ratio of the company is 15, then it means that an investor is willing to pay Rs 15 for Re 1 of the current earnings of the company. A high P/E can be seen as an overvaluation of the stock, while a low P/E may indicate undervaluation. However, not all companies with a higher P/E ratio are overvalued if their earnings and reviews are growing at an amplified pace. P/E ratio is more effective when compared to other companies.

EV/ EBITDA ratio – The EV/ EBITDA is best for evaluating companies that are being merged or acquired. This is used specifically in power, internet and telecom sectors where companies take years to break even and make profits. For them, the P/E ratio is not a good measure.

Price-to-sales ratio – Where companies do not have earnings but have revenues, the benchmark for a valuation could be the P/S ratio. You can calculate the P/S ratio by dividing the current stock price by sales per share. Sales per share are computed by dividing the company’s sales by the total number of outstanding shares. A high P/S ratio means expensive, and a low P/S ratio means cheap.

Price to dividend ratio – The price dividend ratio analyses how much you pay to receive Re 1 in dividend payments. It is useful in comparing the stock value of dividend-paying companies.

Price/Earnings to growth (PEG) ratio – The PEG ratio is the P/E ratio adjusted to growth. It is calculated by dividing the P/E ratio with the company’s earnings growth rate. A company with high PEG ratio and below-average earnings could show an overvalued stock.

Dividend yield – Dividend yield is the dividend per share divided by price per share. It is often used as a measure of stock valuation. Dividend yield and valuation are inversely proportionate. If the dividend yield is higher, the valuation will be lower. But as stock markets prefer high dividend-paying companies, a high dividend yield is not considered too positive.

Return on equity (ROE) – This measures the company’s profitability against equity.  A lower ROE is an indicator of overvalued stocks. This means the company is unable to generate higher income as compared to the shareholders’ investment.

Conclusion:

Identifying overvalued and undervalued stocks will the investor decide what to buy and sell, thereby realising the true potential of every investment.