Understanding Overvaluation of Stocks

One of the key fundamentals of the stock market that investors need to understand is the concept of value. Each share of a public company has a true or intrinsic value that is based on an underlying perception of its actual value, which incorporates all the fundamental aspects of the business, both tangible and intangible.

However, because shares of stock are an actively traded commodity, their price does not always accurately reflect their intrinsic value. Sometimes the price of shares is lower than the stock’s intrinsic value, in which case the stock is considered to be undervalued. Likewise, sometimes the price of shares is higher than the stock’s intrinsic value, in which case the stock is considered overvalued.

Emotions Can Lead to Overvaluation

So why does overvaluation happen? Why don’t stocks trade at their intrinsic value all the time? The main reason is that the buying and selling of stocks by investors is often based more on emotions than it is on the underlying fundamentals of the business.

Investors do not always make buy and sell decisions based solely on business fundamentals like a company’s sales, earnings or future growth prospects. Instead, they often let many other factors influence their decisions, like what other investors and analysts are saying about the prospects of the business or the industry in general. Alternatively, if there is a broad market selloff, investors sometimes panic and sell shares out of fear of losing even more money.

The dot-com boom and bust of the late 1990s-early 2000s is one of the best examples of overvaluation and correction. Investors were bidding up the prices of Internet startup companies to extremely high levels based on little more than excitement about this new medium called the Internet and a widespread belief that any company with a dot-com at the end of its name was destined for phenomenal success.

New Internet businesses that were barely generating any revenue, much less earning a profit, reached sky-high valuations due simply to the fact that so many investors wanted to own a piece of a dot-com business. It was emotion-led investing at its worst, and the result was a bunch of Internet startup businesses that were extremely overvalued. Many of these companies had shaky (at best) business plans, if they had a business plan at all. When it became apparent that many dot-com businesses would never turn a profit, their valuations were quickly corrected, many of them went bankrupt, and the broad stock market plummeted, wiping out billions of dollars in investor wealth.

Another reason for overvaluation is the fact that there are a finite number of shares of stock available for purchase at a given time, so stocks are subject to the laws of supply and demand. When more shares are bought by investors, there are fewer remaining shares for other investors to buy, which drives share prices up, possibly leading to overvaluation. Conversely, when more shares are sold by investors, there are more shares available to be bought. This in turn drives shares prices down, possibly leading to undervaluation.

Strategies for Investors

As an investor, your goal should generally be to buy stocks when they are undervalued, not overvalued. In other words, you want to buy stocks when they are priced lower, not higher, than they are actually worth. Buying stocks that are overvalued could lead to losses when the price eventually declines to a level that more accurately reflects the company’s fundamentals.

The trick, of course, is determining whether a stock is undervalued or overvalued at any particular point in time. The best way to do this is to examine a business’ financial and market fundamentals carefully. These include such metrics as revenue, earnings, balance sheet health, price/earnings (or P/E) and price-to-earnings growth (or PEG) ratios, growth projections, and the growth prospects of the industry the company operates in.

Here are a few things to look for when examining a company’s fundamentals that could indicate that the stock is overvalued:

The P/E ratio is greater than two times the growth rate in diluted earnings per share
The dividend yield is in the lowest 20 percent of its long-term historical range
The company operates in a cyclical industry and its profits are at all-time highs
The earnings yield is less than half the yield on the 30-year Treasury bond

Performing this kind of analysis on a stock before buying will require a little more time and effort than just watching CNBC or Fox Business News or reading Investor’s Business Daily. However, digging into a company’s fundamentals is the best way to determine its intrinsic value — which is the only way to determine whether the stock is overvalued.