What Does It Mean If a Stock Is Overvalued?
Investing
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Stock market analysts warn of overvalued stocks all the time. When they say, "This stock is overvalued," what they really mean is it costs more than it's worth.
Here's a breakdown of what analysts mean when they say a stock is overvalued—and how you, as an investor, can use that information to your advantage.
Overvalued stock, explained
A stock becomes overvalued when its intrinsic value (aka true value) falls below its market value. Analysts come up with a stock's intrinsic value through methods like a discounted cash flow analysis, PE ratio, or asset-based valuation.
This value is usually a little different from its market value, or what its shares are currently worth in the market. However, when the market value is way above intrinsic value, analysts call out the stock for being overpriced.
What happens when a stock is overvalued? It's more likely to experience future volatility, which could mean capital losses for investors depending on their individual cost basis (or buying price). When an analyst suggests a stock may be overvalued, their opinion could be worth listening to.
Can an entire stock market be overvalued?
Individual companies, industries, and sectors of the stock market can be temporarily overvalued. Usually, an entire sector becoming overvalued means a bubble is preparing to burst.
In early Oct. 2021, shortly after the September sell-off, large-cap stocks in the US were 23 percent overvalued. This is an example of a bubble forming, even if it hasn't burst.
Examples of overvalued stocks in the wild
Tesla (NASDAQ:TSLA) whipsawed at the start of November with shares reaching an all-time high of $1,249.59 a pop. Volatility brought a two-percent decline the following day. Some experts say the stock is overvalued (like Jim Cramer, who said "I’ve actually never seen a stock go up endlessly on nothing") but others say it's right on par.
Netflix (NASDAQ:NFLX) also looks overvalued to some. This is because its forward earnings PE ratio (a way to determine intrinsic value) is more than double that of the S&P 500's.
How to determine if a stock is overvalued before buying
Investors should research any public company whose stock they plan to trade. Part of that research is finding out if it's overpriced. Here are some ways to look for overvaluation:
Look at the company's PE ratio (aka earnings forecast). Overvalued stocks tend to have stock prices that are more than 50 times the forecasted earnings.
In most cases, you can look at the price per earnings-to-growth (PEG) ratio and dividend-adjusted PEG ratio. These numbers can provide a true stock value that you can compare to the current price.
Consider what economic cycle the stock's country is currently in. If you're trading US stocks in the Middle East, for example, you'll want to consider the US economic cycle. If the economy is in a growth cycle, the stock may not be overvalued, just responding to the greater economic landscape.
