Overvalued and Undervalued Securities | CFA Level 1 - AnalystPrep (2024)

FAQs

How to calculate overvalued and undervalued stocks? ›

Price-book ratio (P/B)

To calculate it, divide the market price per share by the book value per share. A stock could be overvalued if the P/B ratio is higher than 1.

When a security's current market price is approximately equal to its value estimate, the security is considered to be fairly valued. Conversely, when the market price exceeds the value estimate, the security is overvalued, and so the security is undervalued when the market price is lower than its estimated value.

The sales per share metric is calculated by dividing a company's 12-month sales by the number of outstanding shares. A low P/S ratio in comparison to peers could suggest some undervaluation. A high P/S ratio would suggest overvaluation.

A critical aspect of CAPM is the concept of undervalued and overvalued securities. If the rate of return is greater than the expected return, it would be considered an overvalued security. If the rate of return is less than expected returns, it would be regarded as undervalued security.

Price-to-earnings ratio (P/E)

A company's P/E ratio is the most popular way to measure its value. In essence, it shows how much you'd have to spend to make $1 in profit. A low P/E ratio could mean the stocks are undervalued. P/E ratio is calculated by dividing the price per share by the earnings per share (EPS).

Beta is an input into the CAPM and measures the volatility of a security relative to the overall market. SML is a graphical depiction of the CAPM and plots risks relative to expected returns. A security plotted above the security market line is considered undervalued and one that is below SML is overvalued.

Fundamental analysis is a valuation tool used by stock analysts to determine whether a stock is over- or undervalued by the market. It considers the economic, market, industry, and sector conditions a company operates in and its financial performance.

Overvalued – When an equity investment's yield is less than the Treasury bond yield, the investment is considered to be overvalued and poised for decline. Undervalued – When equity investment's yield is greater than the Treasury bond yield, the investment is considered to be undervalued and poised to increase.

If the PPP exchange rate of a currency implied by the local price of a given good or basket of goods is lower than the currency market exchange rate, then the exchange rate is overvaluing the local currency relative to its real purchasing power, and if the rate implied by the local price is higher than the market ...

How do you know if the S&P 500 is overvalued? ›

One of the easiest ways to get a reading on whether the market is overvalued is to look at the price-to-earnings (P/E) ratio of the S&P 500. With a P/E of 27, the index looks expensive compared to historic levels.

When the intrinsic value is more, the share is undervalued; when the share price is high, the share is overvalued. Generally, undervalued shares are favored over overvalued ones, as the investors buy low and sell high. If the company is performing well, it can give promising returns.

P/E ratio = P/E ratio / Growth rate of the company's EPS. Dividend-adjusted PEG Ratio / (Growth rate of EPS + Dividend paid). Financial experts consider a PEG ratio below 2 to be the threshold; above this, such stock is considered overvalued. Hence, the lower the PEG's value, the more undervalued it is and vice versa.

One of the quickest ways to gauge whether a stock is undervalued is to compare its valuation ratios to the rest of its industry or the overall market. If the ratios are below that of the industry average or a broad market index such as the S&P 500, you may have a bargain on your hands.

The idea is that when the market cap is higher than GDP, the stock market is overvalued. If the market cap is below the GDP, the stock market is undervalued. As you can see from the chart, the two times the market cap was above the GDP was just before the Tech Bubble and before the financial crisis.

For example, if the trailing P/E ratio of XYZ is 25 and its earnings growth rate for the next five years is 15%, then its PEG ratio is 1.67, or 25 divided by 15. Generally speaking, experts consider a PEG ratio of one or less undervalued, as its price is low compared to its expected future growth.

If the PPP exchange rate of a currency implied by the local price of a given good or basket of goods is lower than the currency market exchange rate, then the exchange rate is overvaluing the local currency relative to its real purchasing power, and if the rate implied by the local price is higher than the market ...