How do you know if a stock is undervalued or overvalued?
Price-earnings ratio (P/E)
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.
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.
The P/E ratio is calculated by dividing the market value price per share by the company's earnings per share. A high P/E ratio can mean that a stock's price is high relative to earnings and possibly overvalued. A low P/E ratio might indicate that the current stock price is low relative to earnings.
An undervalued stock is defined as a stock that is selling at a price significantly below what is assumed to be its intrinsic value. For example, if a stock is selling for $50, but it is worth $100 based on predictable future cash flows, then it is an undervalued stock.
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).
The P/B ratio can help you compare the market price of the stock to its book value (company equity divided by number of shares). A stock may be considered undervalued if the P/B ratio is less than one. The current ratio can help you determine a company's ability to pay off its debts.
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.
When a stock is overvalued, it presents an opportunity to go βshortβ by selling its shares. When a stock is undervalued, it presents an opportunity to go βlongβ by buying its shares. Hedge funds and accredited investors sometimes use a combination of short and long positions to play under/overvalued stocks.
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.
What PE is considered undervalued?
Price Earnings (P/E) ratio is one of the most popular ways of valuing a stock. The thumb rule is that a low P/E ratio is a sign of undervaluation while a high P/E ratio is a sign of overvaluation. But such an approach of purely using P/E Ratio to Value a stock is fraught with risks.
S.No. | Name | CMP Rs. |
---|---|---|
2. | West Coast Paper | 621.30 |
3. | Andhra Paper | 505.80 |
4. | C P C L | 946.10 |
5. | Shreyans Inds. | 250.50 |
To give you some sense of what the average for the market is, though, many value investors would refer to 20 to 25 as the average P/E ratio range. And again, like golf, the lower the P/E ratio a company has, the better an investment the metric is saying it is.
What Is "Overvalued"? An overvalued stock has a current price that is not justified by its earnings outlook, known as profit projections, or its price-earnings (P/E) ratio. Consequently, analysts and other economic experts expect the price to drop eventually.
The main point of difference is the variation between the intrinsic value and the share price. When the intrinsic value is more, the share is undervalued; when the share price is high, the share is overvalued.
What happens when a stock is undervalued? Ideally, it's more likely to experience future growth, which could mean capital gains for investors depending on their individual cost basis (or buying price). When a reliable analyst suggests a stock may be undervalued, their opinion could be worth listening to.
Fair Value Estimate for Apple
With its 2-star rating, we believe Apple's stock is overvalued compared with our long-term fair value estimate of $160 per share.
Company | Face Value (in INR) | Total Market Cap (in crore) |
---|---|---|
Oil and Natural Gas Corporation | 5 | 2,28,520 |
Coal India | 10 | 1,77,178 |
Tata Steel | 1 | 127,551 |
Dhanalakshmi Bank | 10 | 745.12 |
S.No. | Company | Industry/Sector |
---|---|---|
1. | Tata Consultancy Services Ltd | IT - Software |
2. | Infosys Ltd | IT - Software |
3. | Hindustan Unilever Ltd | FMCG |
4. | Reliance Industries Ltd | Refineries |
One key benefit of investing in undervalued stocks is the potential for high returns. You may see substantial capital appreciation when the market eventually corrects and prices align with the stock's intrinsic value. Undervalued stocks often come with a margin of safety, reducing the downside risk for investors.
Do you buy or sell an overvalued stock?
By the same token, though, holding on to a company that is overvalued is a risk. In these situations, it's typically best to sell your stock and be happy with the profits you've made no matter what the stock does in the future.
A low P/E indicates a stock's price is low compared to earnings and the company may be losing money. A consistently negative P/E ratio run the risk of bankruptcy.
Stocks with high price-to-earning (P/E) ratios can be overpriced. A stock trading at $40 per share with an EPS of $2 would have a P/E ratio of 20 ($40 divided by $2), as would a stock priced at $20 per share with an EPS of $1 ($20 divided by $1). These two stocks have the same price-to-earnings valuation.
The Relative Value of AMZN stock (131.7 USD) is 25% less than its price (174.63 USD). AMZN has upside potential of 23% compared to the average analyst price target. AMZN has positive Free Cash Flow for the last twelve months.
Over the past twelve months the share price is up 1.19%. Based on the DCF valuation, the stock is overvalued. The DCF value of $112.24 per share is lower than the current market price of $167.20. The Margin of Safety is -48.97%.
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