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According to Warren Buffet, “Price is what you pay, value is what you get.” A stock is said to be overvalued when the price of the stock is indeed more than its actual value. Investors would avoid buying these stocks as they might fear a correction in its price. Day traders and swing traders can earn profits by finding such overvalued stocks and going short on them, expecting some correction in their prices shortly. Thus, identifying overvalued stocks is equally important as finding undervalued stocks.
Value Investing refers to investing in undervalued stocks and going long on them and sell them off when the stock price touches its exact value. Many investors of The Wall Street believe that identifying overvalued stocks is a part of Value Investing. For value investors, finding overvalued stocks helps in 2 different ways: 1) Avoid buying them and 2) If you own stocks that become seriously overvalued, it may be a good idea to sell and put the proceeds back into a different, undervalued stock.
There are hundreds of ratios and metrics, which can be taken into consideration while analyzing a stock. However, overvalued stocks have specific characteristics and features, which aid us in identifying them. Therefore, I have listed down a few metrics/ ratios, which might help investors identify the actual value of a stock.
Price-to-Earnings Ratio (P/E Ratio)
It is the ratio of a company’s current market price to the earnings of the company in the past twelve months. It depicts the number of dollars you pay per $1 earnings of the company.
The easiest way of identifying overvalued stocks is by using this metric. Stocks having a higher P/E than its peers are considered to be overvalued in nature. Higher the P/E, higher are the chances of it being overvalued. However, one thing to be noted here is that this concept is not applicable to all the stocks of the stock market. It might be applicable to some of the stocks. This ratio is useful only while comparing companies in the same industry, not companies in various industries.
Price-to-Book Ratio (P/B Ratio)
It is the ratio of a stock’s current market price to its book value. Book value is the difference between the assets and liabilities of a company. It shows the difference between the market value of a stock and the book value of a stock. P/B ratio is an indicator of what the investors and traders are ready to pay for $1 of a company’s book value.
In this case as well, higher the P/B ratio, the more overvalued the stock is. The reason behind this is that a higher P/B ratio indicates that the market price of a stock is higher than the book value. This ratio might not turn out to be useful in pinpointing all overvalued companies.
Price-to-Sales Ratio (P/S Ratio)
The price to sales ratio of a company is the ratio of the current market price of a company to its sales. A high P/S ratio represents overvaluation and it might act as an alarm bell to the existing investors.
This ratio might not represent the true value of a company because sales do not represent profits. A company might have huge amount of sales but it might be running into losses due to huge capital and revenue expenditure. Hence, this ratio is applicable to companies in a few industries only.
Free Cash Flow
Free Cash Flow is the cash left over after deducting the company’s operational expenses and capital expenditure. It is one of the best indicators of the dividend paying capacity of a company. It has also proved to be an effective indicator of rise and fall of earnings of a company in the future. The higher the value of free cash flows of a company, the better it is for an investor to invest. Low value of free cash flows is an alarm bell for the investors of a company.
Identifying Overvalued Stocks Using MarketXLS
MarketXLS provides certain ready-to-use functions and features using which you can find out and perform analysis on overvalued stocks. Here is a step-by-step procedure using which you can identify overvalued stocks using MarketXLS.
- Open an excel workbook and go in the utilities section and extract the list of all the US stocks which are currently trading in the market.
2. The software will pull the data of all the stocks which are currently trading in the market. The table of stocks, which has been extracted also contains some other useful information like Open, High, Low and Closing prices, volume traded, market capitalization etc. Add a sort and filter option in all the column headings using the data tab. Now, in the filter option beside the ‘Symbol’ heading, search for the stock which you are looking for. In this example, we will be searching for the MSFT stock.
3. Now, only the data of that particular stock, which you have searched for, will be visible. Select the cell which contains the stock ticker and head your cursor to the ‘Key Ratios’ option in the Fundamental Analysis section.
4. The software will pull all the key ratios of the company’s previous quarters. You can add a filter option in the column headings here as well. By doing this, you will be able to search for the valuation metrics more easily. Uncheck the select all option and tick all the boxes of the valuation metrics, which you are looking for. There are 88 ratios from which you can select. Here, I have only searched for the price to book ratio. In this case, the P/B Ratio is high. You can arrive at a conclusion only after analyzing various other metrics and comparing the metrics of this stock with its peers. These ratios are just a part of the valuation analysis using the software.
MarketXLS provides various ready-to-use templates for its users to make the work of analysis and interpretation easy.
This template contains much more advanced functions and metrics, which will give you a deeper insight into the valuation analysis subject.
You can find the detailed procedure of how to use this template and what are the characteristics of this template in this link – https://marketxls.com/comparable-analysis-equity-valuation/
The Bottom Line
The current market price of an overvalued stock is not vindicated by its earnings and overall growth. For a layman, consideration of overvalued stocks isn’t useful because they do not provide profits. But for traders, identifying overvalued stocks is important as they can earn profits by entering into short positions of the stock. In the case of an investor, identification of overvalued stocks is useful so that he doesn’t put his money in those stocks.
Overvaluation is a result of some psychological bias, a scam or a recent deterioration in the company’s fundamentals which has not been noticed by the lazy/ part time investors who hold a stock for a long time without keeping a regular check on it.
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