What is overvalued?
An overvalued security has a current price which is not justified by its earnings prospects, called profit projections, or by its price / earnings ratio (P / E). Therefore, analysts and other economic experts expect the price to fall.
The overvaluation can result from an increase in emotional exchanges or an illogical and instinctive decision, which artificially inflates the stock market price, or from the deterioration of the fundamentals and financial solidity of a company. Potential investors try to avoid overpaying stocks.
The most popular comparison is the P / E ratio, which analyzes a company’s profits relative to its share price. An overvalued company would be one that trades at a rate that is 50 times the profit.
The theory behind overvalued stocks
A small group of market theorists believe that the market is by nature perfectly efficient. They believe that fundamental analysis of a stock is a useless exercise because the stock market is omniscient. As a result, stocks may not be genuinely undervalued or overvalued. On the contrary, fundamental analysts are convinced that there are always opportunities to find undervalued and overvalued stocks because the market is as irrational as its participants.
Overvalued stocks are ideal for investors looking to sell a position; short selling involves selling stocks to buy them back when the price comes back in line with the market. Investors can 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 profits over another.
How to find overvalued stocks
Relative profit analysis is the most common way to identify an overvalued security. This measure compares benefits to a comparable market value, such as price. The most popular comparison is the P / E ratio, which analyzes a company’s profits relative to its share price. An overvalued company would be one that trades at a rate that is 50 times the profit.
Analysts looking for short-term stocks may look for overvalued companies with high P / E ratios, particularly compared to other companies in the same industry or peer group. For example, suppose a company has a stock price of $ 100 and earnings per share of $ 2. The calculation of its P / E ratio consists in dividing the price by the profit ($ 100 / $ 2 = 50). Thus, in this example, the security is trading at 50 times the profits.
If this same company has an exceptional year and makes $ 10 in EPS, the new P / E ratio is $ 100 divided by $ 10, or 10 times ($ 100 / $ 10 = 10). Experts consider the company overvalued if the profit is $ 2 per share, but undervalued if the profit is $ 10 per share.
Example from the real world
Although by definition a stock is only overvalued by the opinion of an analyst, The Motley Fool website never hesitates to weigh. For example, they estimated that automaker Tesla was largely overvalued, due to annual net losses that regularly break the $ 100 mark. million mark. Nevertheless, investors tend to be attracted to the company, because of its attractive vehicles and its avant-garde history.