How To Tell If A Stock Is Overvalued
Avoid bubbly stocks in a volatile stock market
Numerous metrics indicate the stock market is richly valued. Nowadays, it’s easy to find stocks carrying lofty valuations. However, some stocks present less attractive risk-reward ratios than others.
Discovering how to find great growth stocks is a great skill. Part of finding great stocks is deciphering overvalued stocks. The moment you define your investing criteria, you’ll stop following the crowds and only put your money towards investments that align with your risk tolerance.
Investors with high risk tolerances will take more risks. They’ll embrace richly valued stocks that promise incredible potential in a few years. Investors with low risk tolerances will focus on blue chip dividend stocks.
A higher risk tolerance increases the likelihood of adding ridiculously overvalued stocks to your portfolio and getting caught in a downward spiral. Many beginner investors who embrace a high risk tolerance act as if they can never lose money in the long term. “Stonks always go up” as they say.
It’s entirely possible to find undervalued growth stocks. Even in this market, those stocks still exist. The concern is investors focusing on revenue growth rather than the fundamentals and business model. If you want to tell if a stock is overvalued, follow these strategies.
Compare Valuation Numbers
The valuation numbers give us a quick glimpse into the stock’s valuation. Comparing the valuation numbers of appropriate companies will shed light on a stock’s valuation prospects.
Some investors may view a price-to-sales ratio over 10 as a high risk stock. However, if stocks in the same industry have P/S ratios above 20, and the lower valued stock has stronger revenue growth, it might not be overvalued.
Growth investors often use the price-to-sales ratio for judging the value of a stock. The price-to-earnings ratio makes more sense for stable, profitable companies that pay a dividend. Those types of companies rarely see revenue growth beyond 20% YOY. On the other hand, some growth companies doubled their revenue YOY which means today’s 10 P/S ratio will get cut in half the following year (making the gigantic assumption that the stock price remains the same).
The PEG ratio is another popular ratio among growth investors. This ratio is like the P/E ratio except it also factors in growth, a critical element of a growth stock’s lofty valuation.
If you compare growth stocks to bank stocks, they will always appear overvalued. Comparing growth stocks to other growth stocks allows you to better discern overvalued growth stocks from the undervalued growth stocks.
While looking at valuation numbers, also take a look at a company’s revenue and earnings growth over the past few years. You can find all of these numbers by searching a stock on Yahoo! Finance.
If a company fails to demonstrate profitability/narrowing losses and high revenue growth rates, their valuations will take a hit. Stocks receive lofty valuations because of that they can be in a few years rather than what they are now. If you remove the bullish elements of the long term narrative, the stock will take a beating.
Understand The Company
Digging through the numbers and listening to earnings calls are the two best ways to fully understand a company. Media articles present a narrow glimpse of a company’s prospects and overall future. They pull their information from the earnings calls and reviewing a stock’s numbers. Go to the source to learn more about a stock.
Understanding a company also requires a proper understanding of the industry at large. You can’t understand a stock like Etsy unless you understand the e-commerce picture. Stocks can outperform within their industry, but changes within the industry will affect the stock price.
This is why a new ruling on the App Store’s in-app purchasing ecosystem caused many stocks to shoot up in price. Basically, Apple will now allow companies to enable their own purchasing systems rather than rely on Apple. This new rule allows companies to bypass Apple’s cut and significantly boost their earnings.
This is why a new ruling on the App Store’s in-app purchasing ecosystem caused many stocks to shoot up in price. Basically, Apple will now allow companies to enable their own purchasing systems rather than rely on Apple. This new rule allows companies to bypass Apple’s cut and significantly boost their earnings.
The App Store wont’t affect every publicly traded company. Numerous companies have little to no exposure to the App Store. Look into each stock’s strengths, weaknesses, opportunities, and threats before investing.
Conducting this type of research isn’t the best if it’s not your full-time job. Reviewing a company’s financials, valuation, and business model is sufficient in most cases. However, if you find yourself investing more than 5% of your portfolio into a single company, you should conduct a S.W.O.T. analysis to increase your confidence and understanding in that investment.
Inflation Is Coming
Inflation is rearing its ugly head into the economy. Even though inflation hasn’t received much attention from the media, it’s easy to spot in the grocery store, barber shop, and everywhere in between.
Not only does inflation increase the prices of goods and services, but it also hurts company valuations. Part of that ‘long term potential’ narrative is the purchasing power of future earnings. Inflation decreases the purchasing power of those future earnings. Since high growth companies will get less mileage on their future money, valuations will take a hit.
Inflation is especially concerning for the high growth companies with price-to-sales ratios well beyond 20 that rely on world class revenue growth to retain their valuations. The rising risk of inflation is one reason why more investors have shifted from growth stocks to value stocks.
Each investor has a different definition of fair value that directly ties to their risk tolerance. High risk investors rely on a feast or famine approach while conservative investors take a safer approach. Discerning overvalued stocks makes it easier to spot bargains and invest accordingly.