How to Tell If A Stock Is Overvalued

If the 2020 coronavirus pandemic taught investors anything, it’s that some companies aren’t as valuable as they seem. Oil prices dove into the negative, real estate is shaky, retail and even some healthcare companies took massive hits, deflating expectations across the board.

Government stimulus programs will expire in 2021, and we’re going to learn which companies are inflated in a bubble. As Warren Buffett famously said “when the tide goes out, you see who is swimming naked.”

When you understand what you’re looking at, you can be savvy like the Oracle of Omaha too. It takes due diligence into a company’s people, process, and products on one hand, along with a healthy understanding of the underlying financials.

This guide will explain how to tell if a stock is overvalued. You’ll learn what investment firms look for and how they’re evaluated to determine if they’re safe places to store your money.

We’ll also touch on how indices like the S&P 500 and Dow Jones Industrial Average determine their valuations. First, let’s discuss cautionary tales of using the wrong methods.

Beware of Classic Valuation Measures

A stock is essentially overvalued when the market capitalization isn’t supported by profits. Of course, there are a lot of ways to look at profit margins, and three are commonly used by companies to explain their financials:

1.     Price-Earnings

2.     Price-Sales

3.     Price/earnings to Growth

You’ll often see major companies trading for 10 times earnings or more, but there’s more to a company like Amazon than just its revenue, for example.

Amazon and Walmart have major distribution networks and assets that can produce revenue. This is true of any major company in the S&P 500, although some companies can trade for as high as 50 times earnings or more.

The reason this often occurs is because of the valuation method used. Let’s look at each of the three commonly used evaluation methods to explain why they’re used and what they really show.

1.   Why PE Ratio Is Flawed

Price to earnings (PE) is the most basic (and therefore commonly used) method of valuing a company.

You’ll see it throughout investment media outlets discussing how much you’ll spend per share for every $1 of net income.

This completely ignores any assets, resources, and cash flow – in fact, it ignores the company’s balance sheet altogether to zero in on the one number.

PE ratios ignore the capital flow of a company. This means you’ll miss debt and upcoming obligations.

Just because something looks good today doesn’t mean it’s an overall great investment. It’s also hard to compare PE ratios between industries, as a telecom giant like AT&T will have a different expectation than a pharmaceutical giant like Pfizer.

Only looking at the price to earnings of a company ignores the bigger picture of where it fits into which market. It’s a one-size-fits-all look at something that requires more forward-looking nuance to understand future performance.

Tesla, for example, is the largest car company by market cap because of its future growth potential, not necessarily the low number of vehicles it has on the road so far.

2.   Why PS Ratio Is Flawed

The other commonly misused valuation method is price-to-sales. You’ll often hear that sales are the lifeblood of any business, and that’s true.

A company does need to show some impressive sales to get the attention of investors. But sales figures alone won’t reveal operational costs and other expenses rolled into the overhead price and creating the margins.

If a company has higher sales of a low-margin item, it can easily be outperformed by a company with lower sales but higher margins.

You’ll see this play out especially clearly in companies that are brand names versus those that are not. For example, Coca Cola can command higher prices due to its premier brand versus a new start-up, say Joe’s Cola. Even Joe’s Cola had the same distribution and product as Coke, its margins would be worse because of its inability to command higher prices.

Successful investors often seek growth potential, and you can’t see that by looking directly at sales in an apples-to-apples comparison of companies. Even if you knew the margins, you’re just back where you were above. This is why some investors lean toward a third option that also has problems.

3.   Why PEG Is Flawed

PEG ratio takes the PE ratio into account and simply divides by the company’s growth rate. The lower the number, the cheaper a stock is considered to be. However, you’re stuck with many of the challenges for these other calculations – do you look forward or backwards, and what else are you missing?

It’s impossible to know for sure when a company is at its peak or headed for a crash. Companies as large as McDonalds have outperformed their PEG ratios too. This is because nothing so simple could predict the company’s change of directions and pivots meant to generate more profits while lowering overhead costs.

Nothing in this method would explain the impact the PS5 and Xbox have on Sony and Microsoft next year. None of it can account for subscribers versus one-time purchases, nor can PEG fully interpret the reasons for a company’s growth or lack thereof.

Using any of the above valuation methods is inevitably going to end up with false positives. With that said, they’re still often used when investors are evaluating a company.

When you watch any of the shows above, you’ll hear the investors asking the entrepreneurs for sales, earnings, and other financial data. Ultimately what they’re looking for is cash flow, and that’s why the discounted cash flow method is more accurate.

How to Use Discounted Cash Flow Method

The discounted cash flow (DCF) accounting method estimates a company’s value based on future cash flows.

Essentially, you’re investing today based on the assumptions of future profits. You can’t just take someone’s word for it, however. You need to see all of the company’s financial statements and review them with a fine-toothed comb. This is easily the most labor-intensive method, but it’s also the way to really understand what a business is up to.

DCF accounts for the weighted average for cost of capital, while also accounting for investor returns. By the time you invest in any company, there’s a good chance it already has angels and other private investors.

Their stake in the company can take up a large chunk of the company’s actual value. This analysis assumes the time value of money invested today based on future cash flows but also accounts for the past investors, who you’ll eventually need to buy out.

While this does sometimes prove inaccurate in the event of a world-changing event like the coronavirus pandemic, future projections are often stable, especially when dealing with companies that have been around for a long time.

With 10 or more years in business, it shouldn’t be difficult to understand a lot about how a company will do next year.

If you’re not sure where to begin, check out Financhill’s stock valuation tool where you can simply type in a ticker symbol and all the hard work is done for you here >>

How to Tell if a Stock Is Overvalued: The Bottom Line

The biggest worry of 2020 is investing in overvalued businesses. Companies like Apple, Microsoft, and Amazon are racing to become $2 trillion businesses, while others like Tesla are reinventing the wheel.

Each has a massive evaluation that’s multitudes more than their annual revenues and sales. That’s why those are bad ways to value a company.

If you really want to determine a company’s value, using discounted cash flow gives the most accurate possible picture by plugging information from quarterly and annual financial statements into prebuilt templates that can do the calculations for you.

---

The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.