Investing in the stock market requires most active investors to distinguish between undervalued and overvalued stocks in order to achieve great and consistent returns. This article is going to briefly introduce you to how you can determine if a stock is either undervalued, fairly valued, or overvalued.
What’s an Undervalued/Overvalued Stock?
What does it really mean if a stock is undervalued or overvalued?
Have you ever heard of the famous saying “buy low and sell high”? This rule does make sense but it is more difficult to accomplish than it may seem.
If people were always able to buy stocks when prices were “low” and sell as soon as they turn “high”, there would probably be a lot more successful investors, and active investing would be a child’s play. Buying low and selling high essentially means buying undervalued stocks and selling them when they become overvalued. But how do you know what’s low and high?
For instance, if a stock was priced at $5 per share one month ago and is now trading at $20, would it now be the time to sell the stock because its price is now “too high”?
Probably not. You can’t just blindly say that any stock is overvalued as soon as it jumps from $5 to $20 without knowing any further details about the stock itself, can you? $20 is certainly much higher than $5 but that stock could still be considered undervalued.
So in order to determine if a stock is undervalued or overvalued, we would need to look the fundamental value of the underlying business and decide whether the current stock price justifies those fundamentals or not.
The Difference Between Price and Value
This one may seem obvious but it’s one of the most important things to understand about investing in general.
There is a distinct difference between price and value and not every stock price will always reflect the true value of each stock.
For example, as of February 2021, Facebook (FB) is currently trading at around $270 per share. Let’s suppose that the stock price would suddenly jump to the sky the next day. Instead of $270, one share of Facebook would now be tradimg at $2000.
Let’s assume that absolutely nothing has changed within the company or regarding any factors outside the business. 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 offers?
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 $250, $150, or $50 for one share?
Regardless of the price that you choose for yourself, that price point would be what investors call “fair value”. The fair value of a stock is essentially the price that you personally think the stock is worth right now.
Note that this chart is purely made to illustrate the fact that there can always be a divergence between price and value in the stock market (As long as we assume that markets are inefficient, meaning that stock prices don’t always reflect value).
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 use valuation metrics and compare them to other similar companies, historical values, or industry averages.
The most well-known valuation metric is the P/E ratio. If for example, a company is trading at a lower P/E than its competitors, this may indicate that the stock is undervalued, whereas a higher P/E would reveal that the stock may be overvalued.
That being said, using the P/E on its own to value stock is definitely not the only method and can oftentimes be very misleading and 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. 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. 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. The current stock price is lower than its fair value, meaning that the stock is undervalued. You can buy the stock for less than what it’s truly worth right now.
How to Assess the Value of a Stock
Valuation on its own is a huge topic in finance. There are tons of books, papers, and classes out there that cover this subject.
Generally speaking, there are two primary ways 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 similarly trading investments.
The latter doesn’t nearly take as much time and effort than the first approach but also has its own flaws. In the following, we are going to briefly introduce you to relative valuation.
As already mentioned, the easiest and less complicated valuation approach investors can use is applying valuation metrics in order to determine 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 describes the current price of a stock in relation to the earnings of the stock 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.
For instance, if stock A currently trades at a P/E of 15, you would have to pay $15 in order to get $1 as earnings out of the business. Stock B on the other hand, has an earnings multiple of 40, meaning that you would currently have to pay $40 for every $1 in earnings.
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 theoretically appear more overvalued than stock A. 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. You should mainly use the P/E ratio of a stock in comparison with similar companies within the same industry, or with its own historical standards.
As an example, if a company is trading at a P/E of 20, but the historical average of P/E’s for the business is 30, it can be a good sign that the stock is currently undervalued.
The PEG ratio
A major flaw of the P/E ratio is the fact that it doesn’t tell anything about the future since it only represents the current price in relation to the past earnings.
For instance, if a stock has a P/E of 5 but is not growing but instead shrinking, that stock isn’t likely to be a good investment, despite its low P/E. On the flip side, if a stock has a P/E of 50 but is growing tremendously, that company still might be a great and fairly valued investment.
Somehow, the growth aspect needs to be taken into account, and this is where the PEG ratio comes into place.
The PEG ratio is like an enhanced version of the P/E ratio but eliminates one major flaw by additionally considering the growth factor of the company’s earnings.
You can calculate the PEG ratio 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 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 P/E standards.
For example, if you compare stock A with a P/E of 14, and a growth rate of 8% with stock B that has a P/E of 40 but is growing 35%. By using the PEG ratio, you would come up with a PEG ratio 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.
In order to determine whether a stock is undervalued or overvalued, you need to analyze the stock’s fundamental characteristics relative to the current market price.
One approach of assessing a stock’s value is using different metrics ratios and comparing them between different 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, more advanced investors and professionals don’t necessarily just compare valuation metrics in order to come up with the intrinsic value of a company. What is most often being applied in valuation are financial models such as the discounted cash flow, which does take more knowledge and practice to be made use of.
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.