How to tell if stocks are overvalued

Overvalued stocks explained

An overvalued stock is a share that trades at a higher price than its real – ‘fair’ – value. Stocks can be overvalued for different reasons, including decline in a company’s financials and sudden increases in buying, normally caused by emotional decisions.

A key assumption of fundamental analysis is that market prices will correct over time to reflect an asset’s ‘fair’ value, creating opportunities for profit. Traders look for overvalued stocks so that they can use derivatives such as CFD trading to go short on the market.

Why do stocks become overvalued?

Stocks can become overvalued for many reasons, including:

• Surges in demand: trading volume is the amount of market activity over a certain period – it reflects how many stocks were bought and sold in that time. High demand could cause overvaluation of the stocks
• Change in company earnings: when the economy suffers, public spending decreases, which could cause company earnings to drop. If this happens, but the company’s stock price does not adjust to the new earnings level, its stocks could be considered overvalued
• Good news: stocks can become overvalued if they get a lot of positive press coverage
• Cyclical fluctuations: some industries’ stocks perform better over certain quarters than others, which could affect share prices

How to spot overvalued stocks

To spot overvalued stocks, traders use technical and fundamental analysis. Technical analysis is a means of using historical charts to predict price movements. Fundamental analysis is an in-depth method of studying a company’s financials and external factors to gauge the value of an asset. Both forms of analysis should be used to find overvalued stocks. Below we look at some of the fundamental analysis ratios that traders should consider.

Eight ways to spot overvalued stock

As part of fundamental analysis, there are eight ratios commonly used by traders and investors. The following ratios could be used to find overvalued stocks and determine their true value:

1. Price-earnings ratio (P/E)
2. Price-earnings ratio to growth (PEG)
3. Relative dividend yield
4. Debt-equity ratio (D/E)
5. Return on equity (ROE)
6. Earnings yield
7. Current ratio
8. Price-to-book ratio (P/B)

Price-earnings ratio (P/E)

A company’s price-to-earnings ratio (P/E) is one way to measure its stock value. Essentially, it explains how much you’d have to spend to make £1 in profit. A high P/E ratio could mean the stocks are overvalued. Therefore, it could be useful to compare competitor companies’ P/E ratios to find out if the stocks you’re looking to trade are overvalued.

P/E ratio is calculated by dividing the market value per share by the earnings per share. The earnings per share are calculated by dividing the total company profit by the number of shares it has issued.

P/E ratio example: You buy XYZ shares at £100 per share. XYZ has five million shares in circulation and turns a profit of £2 million. This means the earnings per share is 40p (£2 million/five million) and the P/E ratio equals 250 (£100/40p). So, you’ll have to invest £250 for every £1 In profit.

Price-earnings to growth ratio (PEG)

The price-earnings to growth ratio, or PEG ratio for short, looks at the P/E ratio compared to the percentage growth in annual earnings per share. If a company has below average earnings and a high PEG ratio, it could mean that its stock is overvalued.

Price-earnings to growth ratio example: Company XYZ’s price per share is £100 and the earnings per share is £5. This means the P/E ratio is 20 (£100/£5) and the earnings rate is 5% (£5/£100). The PEG ratio would then be equal to 4 (20/5%).

Relative dividend yield

Dividend yield is a company’s annual dividends – the portion of profit paid out to shareholders – compared to its share price. The relative dividend yield is the dividend yield of a single stock compared to that of the entire index, for example the S&P 500.

To calculate the relative dividend yield, first calculate the dividend yield for the company you are analysing by dividing its annual dividend by the current share price. Next, divide the company’s dividend yield by the average dividend yield for the index. A low relative dividend yield could suggest that the shares are overvalued.

Relative dividend yield example: XYZ pays out dividends of $2 per share every year. The current share price is £100, which means the company’s dividend yield is 2% (£2/£100). The average for the index is 4%, which means the relative dividend yield is 0.5 (2%/4%).

Debt-equity ratio (D/E)

The debt-equity ratio (D/E) measures a company’s debt against its assets. A lower ratio could mean that the company gets most of its funding from its shareholders – however, that doesn’t necessarily mean that its stock is overvalued. To establish this, a company’s D/E ratio should always be measured against the average for its competitors. That’s because a ‘good’ or ‘bad’ ratio depends on the industry. D/E ratio is calculated by dividing liabilities by stockholder equity.

Debt-equity example: ABC has £500 million in debt (liabilities) and stockholder equity of £1 billion. The D/E ratio would be 0.5 (£500 million/£1 billion). This means there is $0.50 of debt for every £1 of equity.

Return on equity (ROE)

Return on equity (ROE) measures a company’s profitability against its equity – it is expressed as a percentage. ROE is calculated by dividing net income by stakeholder equity. A low ROE could be a possible indicator of overvalued shares. That’s because it would show that the company is not generating a lot of income relative to the amount of shareholder investment.

Return on equity example: ABC has a net income (income minus liabilities) of £100 million and a stockholder equity of £120 million. Therefore, the ROE is equal to 83% (£100 million/£120 million).

Earnings yield

The earnings yield is basically the opposite of the P/E ratio. It is calculated by dividing earnings per share by the price per share, instead of price per share by earnings. Some traders consider stock to be overvalued if the average interest rate the US government pays when borrowing money (known as the treasury yield) is higher than the earnings yield.

Earnings yield example: ABC has £20 earnings per share and the share price is £60. The earnings yield will be equal to 33% (£20/£60).

Current ratio

A company’s current ratio is a measure of its ability to pay off debts. It is calculated by simply dividing assets by liabilities. A current ratio higher than one normally means liabilities can be adequately covered by the available assets. The higher the current ratio, the higher the likelihood that the stock price will continue to rise – even to the point of it becoming overvalued.

Current ratio example: ABC has £1.8 billion in assets and £1 billion in liabilities (debt), so the current ratio equals 1.8 (£1.8 billion/£1 billion).

Price-book ratio (P/B)

The test of a stock’s true value also lies in the price-to-book ratio (P/B) of the company. This ratio is used to assess the current market price against the company’s book value (total assets minus liabilities, divided by number of shares issued). To calculate it, divide the market price per share by the book value per share. A stock could be overvalued if the P/B ratio is higher than one.

Price-to-book ratio example: ABC’s shares are selling for £50 a share, and its book value per share is £30, which means the P/B ratio is 1.67 (£50/£30).

How to short overvalued stocks

To short overvalued stocks, it’s important to use all of the above ratios as part of your fundamental analysis. The main aim is to find shares with ratios different to the industry norms, then go short on the market. One strategy would be to open a position when the ratios have deviated from the industry norms and close it when they return to the industry standard. Remember, it’s important to consider the findings from your fundamental analysis in the context of technical analysis as well.

Once you’ve identified the overvalued stocks you want to trade, you can open a short position through CFD trading. By going short, you are predicting that the price of the stock will fall towards its ‘fair’ value.