Out of all the investing advice out there, one maxim remains true above all others: buy low, sell high.
The problem? It’s hard to know what’s low and what’s high. Or, for that matter, if an asset is asking more than it’s really worth.
Not sure how to tell if an asset is overvalued? Fortunately, there are ratios for that. Here’s a look at the overvalued asset definition, why it matters, and a few ways to check if an asset’s sticker price matches its intrinsic value.
Overvalued Asset Definition
An overvalued asset is an asset that’s trading for more than its intrinsic value. Put another way, it’s an asset whose current price is not matched by its earnings outlook (profit projections).
This is easy to understand in action. If a stock’s intrinsic value is $10 and it’s currently trading for $20, that stock is overvalued. The trick is to figure out what an asset’s intrinsic value is.
Intrinsic Value, Undervalued, Overvalued
Intrinsic value is a measure of what an asset is worth. This is not calculated by looking at the current asset price, but rather through a complex financial model and objective calculation. There is no universal standard of calculation, but the good news is that there are a few different ways to approach the problem depending on what information is available to you.
To be clear, if an investment trades exactly at its intrinsic value (or close to it), it’s considered fairly valued within a reasonable margin. When an asset trades away from its intrinsic value (or the acceptable margin of error) it’s considered undervalued or overvalued.
Why It Matters
This is more than just a matter of counting pennies.
For example, let’s say you prefer to practice value investing. The entire investment methodology is predicated on intrinsic value, which is calculated using a thorough analysis of the asset in question. No value investor interested in turning a profit would purchase assets for more than their intrinsic value. Instead, they shop around for assets available on the cheap (undervalued) so that they can turn a profit when those assets deliver growth.
Even if you’re not a self-described value investor, you still need to pay attention to intrinsic value. Investment is the art of earning money when an asset grows in value, but if the asset is overvalued when you purchase it, you’re never going to see growth, and you’re not using your investment dollars as efficiently as possible.
Signals of Overvaluation
The good news is that there are several ways to check whether an asset might be overvalued. Essentially, you’re looking at relative earnings analysis. But for those who don’t have the time or inclination to take a financial analysis course, here are a few basic ratios to check an asset’s valuation.
There are more complex options out there, like a price-to-net-present-value analysis. Here, we’re focusing solely on relatively simple ratios to help you get your footing. Once you’re comfortable with these, you can try your hand at more complex analysis (or enlist expert advice). Unfortunately, many ratios focus on stocks, but an expert can help you adapt them to alternative assets.
Price-to-Earnings and Price-to-Earnings-Growth
Two of the most common ratios are price-to-earnings (P/E) and price-to-earnings-growth (PEG).
The P/E ratio is a ratio for valuing a company that focuses on its current share price relative to its earnings per share. The formula is quite simple: just divide the market value per share (the current stock price) by the earnings per share.
You can look up the stock price on any finance website, but the earnings per share is more nebulous. There are two types: trailing 12 months (TTM, signaling the company’s performance over the last 12 months) and EPS guidance (the company’s best guess of their earnings per share, available in the annual earnings release).
The higher the P/E, the more speculation that’s built into the price. Lower P/E is usually more reasonable, but if it’s significantly lower than the company’s peers, this can indicate undervaluation.
PEG is an extension of P/E analysis, which divides the stock’s P/E ratio by the growth rate of its earnings. This can help tell you whether a low P/E is good or bad. The lower the PEG, the more the company may be undervalued for its industry.
Price-to-Book
The price-to-book (P/B) ratio compares a company’s market valuation to its book value. An asset’s book value is equal to its carrying value on the balance sheet, and the market value of equity is usually higher than the company’s book value.
To calculate the P/B ratio, divide the market price per share by the book value per share. Book value is calculated as follows:
Book value = (total assets – total liabilities) / number of shares outstanding
In other words, if a company liquidated all of its assets and paid off all of its debts, the remaining money would be the company’s book value.
A low P/B ratio may mean the company is undervalued, or it could mean that something is dangerously wrong with the company. Conversely, the higher the P/B ratio, the more inflated the stock price.
Either way, the ratio reflects the value that market participants attach to a company relative to the book value of its equity. And much like P/E, any company’s P/B ratio is best understood in the context of the P/B ratios of its peers. This will give you a clear idea of whether the company is typical for its industry and thus how to interpret the ratio in each unique case.
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