How to know if a stock is undervalued or overvalued?
Knowing how to identify whether a stock is under or overvalued can be key to success as an investor.
How to tell if a stock is undervalued or overvalued?
There are several ways to tell if a stock is undervalued or overvalued, but no single method is foolproof. Here are some common methods:
- Fundamental analysis: Fundamental analysis involves evaluating a company's financial and economic fundamentals, such as its revenue, earnings, cash flow, debt, assets, liabilities, and growth prospects. A company that has strong fundamentals, but a low stock price may be undervalued, while a company that has weak fundamentals, but a high stock price may be overvalued.
- Technical analysis: Technical analysis involves analysing a stock's price and trading volume data to identify patterns and trends. Technical analysts use charts and technical indicators to identify support and resistance levels, trend lines, moving averages, and other factors that may indicate whether a stock is undervalued or overvalued.
- Valuation ratios: Valuation ratios involve comparing a company's stock price to its financial metrics, such as earnings per share (EPS), price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, price-to-book (P/B) ratio, and dividend yield. A company with a low valuation ratio relative to its industry peers may be undervalued, while a company with a high valuation ratio may be overvalued.
- Market sentiment: Market sentiment looks at evaluating the overall mood and sentiment of the market toward a particular stock or sector. If there is positive news or hype around a stock, it may be overvalued, while negative news or pessimism may indicate an undervalued stock.
- Qualitative factors: Qualitative factors involve considering non-financial factors that may affect a company's stock price, such as management quality, brand reputation, competitive advantage, regulatory environment, and market trends. A company that has a strong competitive position and a favourable industry outlook may be undervalued, while a company with poor management or regulatory issues may be overvalued.
It's important to note that these methods are not mutually exclusive, and investors may use a combination of these approaches to determine whether a stock is undervalued or overvalued.
Ways to tell if a stock is undervalued
Some common metrics to consider whether a stock could be undervalued are:
Price-to-Earnings (P/E) ratio
A company's price to earnings ratio is its stock price divided by its earnings per share (EPS). If a stock has a low P/E ratio compared to its peers or the broader market, it may be undervalued. A low P/E ratio could indicate that investors are not valuing the company's future growth prospects or that the stock is oversold.
🎓 Learn more: What is a good P/E ratio for stocks?→
Price-to-Book (P/B) ratio
A company's P/B ratio is its stock price divided by its book value per share. A low P/B ratio may indicate that investors are not valuing the company's net assets or equity, which could make the stock undervalued.
Discounted Cash Flow (DCF) analysis
DCF analysis is a method of estimating the intrinsic value of a stock based on its future cash flows. If a stock's DCF value is higher than its current stock price, it may be undervalued.
Technical Indicators
Technical indicators, such as Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD), can also help to identify whether a stock is oversold. If a stock's RSI is below 20 or its MACD is showing a bullish crossover, it may indicate that the stock is oversold and due for a correction.
Ways to tell if a stock is overvalued
Most of the indicators and metrics used to check if the market value of a stock is undervalued can be inverted to check if a stock is overvalued:
Price-to-Earnings (P/E) ratio
A company's price-to-earnings ratio is its stock price divided by its earnings per share (EPS). If a stock has a high P/E ratio compared to its peers or the broader market, it may be overvalued. A high P/E ratio could indicate that investors are willing to pay a premium for the company's future growth prospects, or that the stock is in a bubble.
Price-to-Book (P/B) ratio
A company's P/B ratio is its stock price divided by its book value per share. A high P/B ratio may indicate that investors are willing to pay a premium for the company's net assets or equity, which could make the stock overvalued.
Discounted Cash Flow (DCF) analysis:
If a stock's DCF value is lower than its current stock price, it may be overvalued.
Technical indicators
Technical indicators, such as Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD), can also help to identify whether a stock is overbought. If a stock's RSI is above 70 or its MACD is showing a bearish crossover, it may indicate that the stock is overbought and due for a correction.
🎓 Learn more: How to research stocks: 7 steps to follow→
Why do stocks become undervalued?
Stocks can become undervalued for several reasons, such as:
- Negative news or events: Negative news or events, such as a decline in earnings or a scandal involving company management, can cause investors to lose confidence in a company, leading to a decrease in demand for its stock and a drop in its price. If the decline in price is not reflective of the company's underlying fundamentals, the stock may become undervalued.
- Cyclical or sector trends: Certain sectors or industries may fall out of favour with investors due to cyclical trends or changing market conditions. This can lead to a decline in demand for the stocks in these sectors, causing them to become undervalued.
- Market correction: A market correction, which is a rapid and widespread decline in the stock market, can cause even fundamentally sound companies to experience a drop in their stock price. If the decline is not reflective of the company's underlying fundamentals, the stock may become undervalued.
- Fear and panic: Fear and panic can cause investors to sell their stocks en masse, leading to a decline in demand and a drop in prices. This can create buying opportunities for value investors who believe that the market overreacted to the news or events.
- Mispricing: Stocks may become mispriced due to investor irrationality or errors in valuation models. This can lead to a disconnect between the stock's price and its underlying fundamentals, making it undervalued.
It's important to note that undervalued stocks are not necessarily a good investment, as they may continue to decline in price if the company's underlying fundamentals are weak or if the market conditions remain unfavourable.
Why do stocks become overvalued?
Much like the above, stocks can become overvalued for several reasons:
- Speculation: Investors may speculate on a stock's future growth potential, leading to increased demand and a rise in the stock price. This can create a bubble in the stock market, where the stock's price becomes disconnected from its underlying fundamentals.
- Market hype: Positive news or rumours about a company can generate hype in the market and drive up the stock price. This hype can be fuelled by social media, news outlets, or even analysts who issue optimistic reports.
- Investor sentiment: Investor sentiment can drive a share price higher or lower, regardless of the company's underlying fundamentals. If investors are optimistic about a company's future prospects, they may bid up the stock price, leading to an overvalued stock.
- Irrational exuberance: The stock market can be subject to irrational exuberance, where investors become overly optimistic about a stock's future prospects and drive up the price. This can lead to an overvalued stock that is disconnected from its underlying fundamentals.
- Low interest rates: Low interest rates can make stocks more attractive to investors who are seeking higher returns. This increased demand for stocks can drive up the stock price, leading to an overvalued stock.
It's important to note that overvalued stocks are not necessarily a bad thing for investors, as they can still generate positive returns in the short term.
However, over the long term, an overvalued stock is likely to correct itself, which can result in a significant loss for investors who bought the stock at an inflated price. Therefore, investors should be cautious when investing in overvalued stocks and conduct thorough research and analysis to ensure they are not paying too much for a stock.
Undervalued vs overvalued stocks
Here is a comparison between undervalued and overvalued stocks:
Undervalued stocks | Overvalued stocks |
|---|---|
Have a lower market price than their intrinsic value | Have a higher market price than their intrinsic value |
Offer a potential buying opportunity for investors who believe that the market has undervalued the stock | Offer a potential selling opportunity for investors who believe that the market has overvalued the stock |
Are usually associated with companies that have strong fundamentals, but are experiencing temporary setbacks or negative sentiment in the market | Are usually associated with companies that have weak fundamentals, but are experiencing positive sentiment or hype in the market |
May be a good long-term investment opportunity if the company's fundamentals are strong and the market conditions are expected to improve | May be a risky investment opportunity, as the stock price may not be sustainable and may eventually decline |
Are generally considered to be part of a value investment strategy | Are generally considered to be part of a growth investing strategy |
May require patience and a long-term investment horizon to realise potential gains | May require a more active investment approach, such as timing the market or actively managing the portfolio |
🎓 Learn more: What is value investing?→
Undervalued vs overvalued FAQs
Are undervalued stocks a good investment?
Undervalued stocks can be a good investment opportunity, but it depends on the specific company and the reasons why the stock is undervalued.
If a stock is undervalued due to temporary market conditions or negative sentiment, but the company's fundamentals are strong and there are catalysts for future growth, then it may be a good investment opportunity. Investors who are patient and have a long-term investment horizon may be able to benefit from buying undervalued stocks at a discount and holding them until the market recognises their true value.
However, if a stock is undervalued due to weak fundamentals or a declining growth rate or industry trend, then it may not be a good investment opportunity. Investors should conduct thorough research and analysis to understand why the stock is undervalued and whether there is a reasonable expectation of future growth.
It's also important to note that investing in undervalued stocks can be risky, as the stock price may continue to decline or may take a long time to recover.
Should you avoid buying overvalued stocks?
As a general rule, it is usually not advisable to buy overvalued stocks. When a stock is overvalued, it means that the market price is higher than the stock's intrinsic value, which may make it difficult for the stock to continue to deliver positive returns over the long term.
Overvalued stocks may be a product of market hype, speculation, or irrational exuberance, and the current market price may not be sustainable in the long run. If investors buy an overvalued stock at a high price, they may experience losses if the stock price eventually drops to reflect its true intrinsic value.
However, there may be certain situations where an investor believes that an overvalued stock still has room for growth, such as if the company's earnings show growth, has strong fundamentals, innovative products or services, or has a competitive advantage in its industry.
In these cases, investors may still choose to invest in the overvalued stock, but they should do so with caution and with a thorough understanding of the company's business model, financial performance, and future growth prospects.
Stella is a markets analyst and writer with almost a decade of investing experience. With a Masters in Accounting from the University of Sydney, she specialises in financial statement analysis and financial modelling. Previously, she worked as an equity analyst at Australian finance start-up, Simply Wall St, where she took charge of the market insights newsletter sent out to over a million subscribers. At Stake, Stella has been key to producing the weekly Wrap articles and social media content.
