Active investing requires taking measures to differentiate between overvalued stocks, fairly traded stocks, and stocks that are trading below their value, in order to achieve admirable and worthwhile returns in a consistent manner. This article is going to briefly introduce you to the topic of stock valuation and approaches of how you can assess whether a stock is under or overvalued.
What Are Undervalued/Overvalued Stocks?
If you’re already familiar with investing, chances are that you’ve probably heard of the common saying “buy low and sell high”. While this adage is truly all that needs to be done to achieve incredible success in the investing world, it is much more difficult to accomplish than it may seem.
If most people were always able to buy stocks when prices were “low” and sell as soon as they rose to “high” levels, investing would be a piece of cake, and there wouldn’t be any professional analysts and fund managers who spend their whole career trying to execute just that.
Buying low and selling high essentially means buying undervalued stocks and selling them as soon as they become overvalued. But the big question remains: how do you know what’s low and what’s high? If company ABC was trading at $5 per share one month ago and is now priced at $20, would it now be the proper time to sell the stock?
Maybe, maybe not. The answer isn’t obvious because we can’t just blindly assume that the stock of ABC has become overvalued the moment its price has jumped from $5 to $20, without knowing any further details about the business itself. Even though the price has quadrupled, company ABC could still be undervalued if its “true” value was $50, to begin with.
Since a stock is nothing more than a share of an actual business, we might as well treat each stock like a business that we consider buying: what are the characteristics that you would be looking for when someone had offered you a business? You would probably pay close attention to the amount of money that you’d be able to receive as the future owner of the business. In addition to that, it would also be crucial to know how long that business is going to last, and how risky it is.
These really are the three key fundamental attributes that need to be evaluated in order to attach an intrinsic value to any cash flow generating asset. So in order to determine whether a stock is undervalued or overvalued, we would need to assess the fundamental value of the underlying business and decide whether the current market price justifies those fundamentals or not.
The Difference Between Price and Value
While this may seem obvious, one of the most important things to understand about investing in general is that there is a distinct difference between price and value of stocks and that not every stock price will always reflect true value of the stock.
In fact, the divergence between price and value is essentially what allows for taking advantage of undervalued stocks and outperforming the average return of the market.
As of June 2021, Facebook (FB) is currently trading at around $330 per share. Let’s suppose that the stock price would suddenly jump to the roof within the next few days. Instead of $320, one share of Facebook would now be trading at $2000.
Assume that absolutely nothing has fundamentally changed within the company, would you consider buying the stock? Or would a price of $2000 per share just seem too ridiculous to you for what the company currently is?
If you wouldn’t be willing to pay $2000 for the stock, how much would you pay if you had the choice? Would it be $500, $250, or even $50 for one share? Regardless of the price that you attach to the company for what it’s worth, that price would be what investors call your estimate of a stock’s “fair value/intrinsic value”. Any active investment philosophy is based on the assumption that stock prices don’t always reflect value and that markets make mistakes.
The following chart simply illustrates the fact that there can always be a disconnect between the price and value of a stock (as long as we assume that markets are inefficient, meaning that they make mistakes but correct themselves over time).
How to Tell Whether a Stock Is Undervalued or Overvalued
One of the options for you to determine whether a stock is undervalued or overvalued is to apply valuation metrics and comparing them to other similar companies, historical values, or industry averages.
The most well-known metric is the P/E ratio. A company that is trading at a lower P/E than its competitors may indicate that the stock is undervalued, whereas a higher P/E might suggest that the stock is overvalued.
That being said, using the P/E alone to assess the value of a stock is not the only approach (and certainly not the best) because it can oftentimes be misleading and simply insufficient. Before we cover the P/E ratio and other metrics in more detail, lets quickly go through each situation that you can possibly encounter when assessing the value of a stock:
- 1. Price > Value. The current stock price is higher than its fair value, meaning that the stock is overvalued. You would currently pay a premium for what it’s truly worth.
- 2. Price = Value. The current stock price is equal to its fair value. The stock price is where it’s supposed to be and you would be able to buy the stock for its intrinsic value (fair value).
- 3. Price < Value. The current stock price is lower than its fair value, meaning that the stock is undervalued. The stock can be bought for less than what it’s truly worth right now.
How to Assess the Value of a Stock
Valuation on its own is a very large and comprehensive topic in finance. There are tons of books, papers, and classes out there that cover this subject.
Generally speaking, there are two primary approaches in how you can assess the value of a stock. The first is absolute valuation (also called intrinsic valuation), in which you try to estimate a certain value of an asset based on its fundamental characteristics. The second approach is relative valuation (or pricing), where you try to gauge the value of a company by comparing its price with similar investments.
The latter doesn’t nearly take as much time and effort than the first approach but also has its own flaws and limits. That being said, here are some of the most common pricing metrics that can help you assess whether a stock is either undervalued, fairly valued, or overvalued.
The P/E ratio
The most commonly used metric when it comes to investing is the price-to-earnings ratio. The earnings multiple reflects the current price of a stock in relation to the earnings of the company in a quick and easily understandable way.
You can calculate the P/E ratio by dividing the current stock price with the earnings-per-share (EPS) of the business:
Whereas earnings per share is the amount of a company’s net profit divided by the number of outstanding shares:
The higher the P/E ratio, the more overvalued a stock may be. Conversely, a lower P/E might indicate a more undervalued stock.
One way to look at the P/E is by imagining how much you would have to pay for $1 in earnings out of the business. Regardless of the price that you attach to the company for what it’s worth, that price would be what investors call your estimate of a stock’s “fair value/intrinsic value”. Any active investment philosophy is based on the assumption that stock prices don’t always reflect value and that markets make mistakes.
As a result, you would have to pay to a higher degree for stock B’s earnings compared to stock A. In this case, stock B would appear more overvalued than stock A from an earnings standpoint. However, not every stock that has a higher P/E than others is necessarily more overvalued.
This is mainly because investors are willing to pay higher premiums for companies that offer higher growth potential. A business like Netflix is simply expected to grow more rapidly than a financial bank like JPMorgan, meaning that investors will overpay, despite the current prospects of the company.
Comparing P/Es of tech stocks with financial stocks is like comparing apples to oranges. It doesn’t really make sense. That’s why the PE ratio of a stock should mainly be used in comparison with similar companies within the industry, or with its own historical standards.
For instance, if a mature company is trading at a P/E of 20, while the historical average of P/E’s for the business is 30, that can be a sign of undervaluation which should be investigated further.
The PEG ratio
A major flaw of the P/E ratio is its lack of any future assumptions. In its basic form, the only two components of the price-to-earnings ratio are the recent earnings and the current stock price.
If a stock has a P/E of 5 but is not growing but instead shrinking in the future, that stock isn’t likely to be a good investment, despite its low P/E ratio. On the flip side, if a stock has a P/E of 50 but is expected to grow tremendously, that company might turn out to be a great investment even if its earnings multiple is high.
Somehow, the future prospects of a company need to be taken into account, and this is where the PEG ratio comes into place.
The PEG ratio, popularized by Peter Lynch, is like an enhanced version of the P/E ratio because it expands the limits by additionally considering the growth factor of the company’s earnings.
The PEG ratio is calculated by dividing the P/E ratio by the EPS growth estimate of the company:
You can either anticipate the earnings growth for yourself or use the estimates of analysts. Most analysts usually calculate earnings growth based on the percentage change of EPS over the previous 12 month period.
Note that the PEG ratio for each stock can vary, depending on the growth rate that is has been used in the calculation. This makes the PEG ratio a little harder to use than the P/E ratio.
Company XYZ is a mature company with a P/E of 18 times earnings. A large number of analysts expect the stock’s earnings to grow 12% annually over the next 3 years. Consequently, you would have to divide the P/E of 18 by the growth rate of 14% to arrive at a PEG ratio of 1.29.
Interpreting the PEG Ratio
In theory, a PEG ratio of below 1 suggests that the company is undervalued, while a PEG ratio of 1 should reflect a fairly valued stock, A PEG ratio above 1 would indicate that the stock is rather overvalued.
The general rule is that the lower the PEG ratio, the more undervalued a stock might be, whereas a PEG ratio of above 2 should raise skepticism, as that indicates a very overvalued stock.
One advantage of using the PEG ratio is that it lets you compare stocks with different growth standards.
If, for example, you compare company A with a P/E of 14, and a growth rate of 8% with company B that has a P/E of 40 but is growing 35%, you would be able to assess each value with the PEG ratio. Calculating the PEG ratio would lead to a PEG of 1.75 for stock A and 1.14 for stock B.
From this perspective, stock B would be more undervalued than stock A, despite the fact that stock B has a much higher earnings multiple since the immense earnings growth of company B is now taken into account.
In order to determine whether a stock is undervalued or overvalued, its fundamental characteristics needs to be analyzed and compared in relation to the current market price.
One approach to assessing a stock’s value is applying different financial metrics and comparing them between similar companies and historical records.
Both the P/E ratio and the PEG ratio have their own benefits and flaws. While the P/E ratio can be used to quickly gauge the value of a stock, it can also be misleading in many cases. The PEG ratio eliminates a major flaw of the P/E ratio and allows comparisons between all types of companies across different industries but depends on accurate growth estimates.
All that being said, advanced investors and professionals don’t necessarily just rely on valuation metrics to make final investment decisions. What is most often applied in valuation are absolute models such as the discounted cash flow (DCF), which requires a deeper expertise and further assumptions about the company that is being valued.
Nevertheless, valuation metrics such as the P/E and PEG ratio can still come in very handy when trying to quickly gauge the value of a stock.