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Overvalued or undervalued stock: how to tell the difference

Overvalued or undervalued stock: how to tell the difference
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Being able to tell whether a stock is overvalued or undervalued and understanding share valuation isn’t a simple science. Professional and retail investors alike spend heaps of time trying to determine the answer.

Figuring this out isn’t a piece of cake, but there are some strategies you can use to give you an idea about stock valuation. I’ll explain some key differences so that you can sharpen your skills.

What is a stock valuation?

Valuing a stock is a way to try and see whether the current share price reflects the true value of the company.

There are lots of different methods we can use to try and determine whether a stock is overvalued or undervalued. Value investing is one popular strategy that uses fundamental analysis to work out whether it’s a good deal.

This is a type of stock analysis that you can do yourself. Public companies have to publish details like their financial records. So eagle-eyed investors can sift through and see how the business is doing.

What is overvalued stock?

Stock is overvalued when the price of an individual share is higher than its intrinsic value.

Intrinsic value is just what investors believe a share price should be based on financial modelling and assessment of the company.

Overvaluation of a stock may be due to a number of reasons:

  • It is a popular company and the demand drives the share price up
  • The company has high projections for long-term growth
  • The business is in an up-and-coming industry or a growing market

Most stock overvaluation is due to future promises. Share prices reflect a glimpse into the future rather than mirroring what is happening right now.

It might seem stupid that people knowingly buy overvalued stock but it’s really common. Even if a stock price is inflated, it could still rise further because investors think there is growth potential. That said, the price could also drop if the company’s performance doesn’t live up to its promise.

What is an undervalued stock?

This is when the share price of a company is less than the perceived value and doesn’t reflect what that stock or business is worth.

It can happen for a number of reasons:

  • People in the market are distracted or the company has some bad press
  • The whole market is down
  • Investors are sceptical about the business or think they can make more money elsewhere
  • The business is facing short-term problems or obstacles

Although a stock that seems undervalued can provide a good buying opportunity, it’s important to remember that valuing isn’t always a pure science. A business that appears undervalued is by no means guaranteed to make investors money. The price could still easily stagnate or even drop.

How do I calculate whether a stock is overvalued or undervalued?

There are plenty of methods that work to some degree. Because companies and industries can be very different in how they operate, you can’t apply the same tests to every one.

In the past, business models were often simpler. So it can be easier to analyse a business with a more traditional structure. These days, share valuation can be harder because of the complex ways companies make money.

It is worth being able to navigate your way around a balance sheet. Even if it doesn’t help your current investing strategy, it’s a useful skill.

You can apply many old-school methods to at least get an idea of where a company’s valuation stands. Key things to look out for are:

  • Price to earnings (P/E ratio)
  • Earnings per share (EPS)
  • Price to book (P/B ratio)
  • Operating profit margin
  • Debt ratios
  • Dividend payout ratio

Takeaway

How to determine whether a stock is overvalued or undervalued will vary between industries.

If you are looking to invest in a company, it’s always worth comparing their financials against similar businesses or competitors. This way you can see how their share valuation compares to their peers.

Comparisons are never going to be apples for apples but it will be better than comparing the value of a construction company to the value of a technology company.

Some share dealing platforms will do a lot of this research for you, which can be helpful if this sort of thing doesn’t float your boat! Or you can always use an investing solutions provider and managed funds to let professionals select your investments for you.

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