It’s important to carefully research fundamentals of every company in which you are planning to invest or invested to know its true value. In this article we will be discussing how an investor can sense when a stock is overvalued or undervalued by using Price to earnings or P/E ratio. Before we start, let us understand the meaning of overvalued or undervalued.
What is overvalued stock?
A stock is overvalued when its market price is not supported by its current price to earnings ratio or profit projections. This means it’s trading at a high P/E ratio in comparison to industry average P/E ratio. If a particular company is overvalued, financial analysts expect that company’s share price to drop.
In general, overvaluation takes place when investors emotionally or illogically buy stocks. Investors trade in overvalued stocks at a premium due to brand value, management, surge in demand by rising investor confidence and other factors. Knowledgeable investors always avoid overvalued companies.
When a stock is overvalued, investors always try to short a position. This means they sell shares at present market price to repurchase when price falls back in line with the market expectation.
What is undervalued stock?
A stock is undervalued when it’s trading for a price presumed to be below the true worth or intrinsic value. This means the undervalued stock is believed to be priced below the industry average P/E ratio.
Intrinsic value can be determined by analyzing a company’s financial statements, future profit generating capabilities and management.
Value Investors acquire shares of undervalued companies as these are likely to provide more value in future.
How to sense overvaluation or undervaluation of stocks by using P/E ratio
The most popular and easiest way to find out when a stock is overvalued or undervalued is comparison of P/E ratios. P/E or price to earnings ratio is calculated by dividing the company’s current market price per share by the earnings per share or EPS.
For instance if a company’s stock is trading at 100 times of its earnings (with P/E ratio of 100), it’s considered as overvalued to another company in the same industry which is trading at 10 times of its earnings (with P/E ratio of 10).
In order to make money, investors will choose stocks that will increase in price over time. This means investors will be willing to buy shares of those companies that are selling for less than it is worth. This type of stocks are considered undervalued.
For instance if a company’s stock is trading at 10 times of its earnings, it’s considered as undervalued in compare to another company in the same industry which is trading at 40 times of its earnings.
One of the best ways is to identify several competitors and compare the P/E ratio of those stocks with the one you are analyzing. If the price to earnings ratio of your company is higher than the majority of relevant competitors, then you can consider your stock is overvalued.
If P/E ratio of your stock is lower than the majority of relevant competitors, then it’s undervalued and can be considered for investing after further research.
Another best way to use the profit to earnings ratio to know when a stock is overvalued or undervalued is to compare it with the industry average P/E ratio. You need to take an average P/E ratio of all the companies in the sector or industry and compare it with your stock’s P/E ratio.
Please note, just because a stock is undervalued on the basis of P/E ratios, it doesn’t mean that as an investor you should buy it. Before investing, you should do further research on it to confirm your decision of buying.
You can use Price/Earnings to Growth or PEG ratio, P/B or price to book value ratio, price to sales ratio and other financial tools to know when a stock is overvalued or undervalued. In addition to all these financial analysis tools, you should get answers to the following questions before investing;
- Is the management honest?
- Are they losing major customers?
- Are they going to grow at a higher rate in comparison to average industry standards?
- Does the business model have higher growth rate?
- What is the stock’s intrinsic value and margin of safety?
Buying on the basis undervaluation or overvaluation of stock is known as value investing. Investors like warren buffet focuses on buying undervalued stocks with higher margin of safety. This model helps them to make higher profits as share price increases over time after investing.