What Is the Meaning of Overvalued Stock?

The stock market looks complicated for the average person. If you don’t know what you’re looking at, it can be hard to understand why Apple Inc (NASDAQ:AAPL), Amazon.com, Inc. (NASDAQ:AMZN), and Microsoft Corporation (NASDAQ:MSFT) have similar market capitalizations and wildly different share prices.

But what is the meaning of overvalued stock, and can each of these companies justify their valuations?

Companies are not valued based on a single method. Usually a combination of approaches is used. For example, one approach is called “comps”, meaning competitors.

Using comps, each of these three technology giants’ valuations can be compared using a  price to earnings (P/E) ratio. If one has a price level that is disproportionately high relative to its earnings, it could be considered overvalued.

Some analysts believe there is another market bubble about to pop. Companies like Zoom (ZM), Peloton (PTON), and Moderna (MRNA) experienced massive market growth, while initial public offerings (IPOs) like DoorDash, Airbnb (ABNB), and Wish are feared to be overvalued.

As an investor, how do you analyze a company in a way that warning signs are obvious when they are overvalued or undervalued?

In a few moments, you’ll understand how to value your own portfolio of stocks to gauge whether they are too frothy or have much more upside. To begin, here are some commonly used valuation measures.

What Valuation Measures Are Used for Stocks?

Publicly traded companies are relatively easy to value. This is because the Securities and Exchanges Commission (SEC) requires they file quarterly earnings reports to give investors an idea of how they are doing.

They are also required to comply with the Sarbanes-Oxley Act of 2002, which outlines public financial transparency regulations.

Here are four common ways to value a company. It’s not an either/or situation – each should be used in tangent to get a fuller picture of the investment’s true value.

1. Discounted Cash Flow Analysis

Discounted cash flow (DCF) determines a company’s value using its future cash flows. Today’s value reflects the company’s future revenue generation and ability to turn those into bottom line profits and cash flows. This is especially useful for companies that have business-to-business (B2B) models or government contracts.

Enterprise and other organizations often sign multi-year contracts that have specific targets that must be met. These contractual obligations are better guarantees of future top line revenues when compared to business-to-customer (B2C) companies, who hope individual retail customers will return to purchase more goods.

The problem with a DCF valuation is it relies on future revenues. We saw in the travel and retail industries especially how forecasts can be thrown out the window during a global pandemic. There’s no telling when the next market-shaking event will happen.

Companies like Zoom (ZM) and Peloton (PTON) became investor darlings during worldwide lockdowns, but their future growth potential is cloudy when the economy reopens.

2. Price-to-Earnings Ratio

Another popular measure to value companies is by their P/E ratios. This means their price per share is divided by their earnings per share.

The higher a company’s P/E ratio, the more of a premium that investors are paying over its actual earnings.

Quarterly earnings reports typically have an earnings-per-share (EPS) number listed. This is because accountants know investors like to divide the share price by EPS to determine the company’s P/E ratio.

Higher P/E ratios are a signal that a company is overvalued, but the ratio must be compared to other companies in the same industry. For example, both Microsoft and Apple had P/E ratios in the 30s during the 2020 holiday season.

By comparison, Amazon (AMZN) is nearing 100 and Tesla (TSLA) is over 1,000. For many bearish investors, this is a sign that Amazon and especially Tesla may be overvalued. Calls to sell both rang throughout markets in the winter of 2020.

The problem is P/E ratio doesn’t take into account the networks these two companies are building. Amazon slowly built out a logistical network that’s competing with FedEx (FDX), UPS (UPS), and the Post Office.

Tesla (TSLA) is building a network of charging stations that could put gas stations out of business over the next 30 years.

Of course, having dreams and executing them are two different things, even for the biggest of companies.

3. Price to Free Cash Flow

Price to free cash flow (FCF) determines a company’s value by dividing the market capitalization by its FCF.

Cash is king in business, and the Amazon and Tesla buildouts can only happen if the companies continue to generate cash to spend on their upgrades.

Energy and telecommunication companies are facing a similar problem in which much of their free cash flow is tied up in infrastructure upgrades that will pay off in future revenues.

Cash flow is best used to evaluate a company over time to determine how well it handles its debt load. If its cash flow increases over time, then it has more money to spend on further upgrades to continue scaling. This is a sign of an undervalued company.

4. Company Financials Compared to Rivals

Some analysts argue that you can only truly measure a company by examining competitors in the same space.

A telecommunications company like Verizon (VZ) has different investor expectations than an airline like Delta (DAL) or a bank like JPMorgan Chase (JPM).

Airlines and cruise lines took a terrible beating in 2020, but they all suffered relatively similar fates in comparison to each other. On the other hand, technology stocks inflated as internet infrastructure became a vital resource during the pandemic.

Speaking of the pandemic, it drove a lot of companies into debt, so let’s explore that.

Does a Company’s Debt Affect a Stock’s Value?

However, this isn’t always the most effective way of measuring a stock’s value. If the company has a massive load of debt, for example, that eats away at the revenues and profits it earns. According to U.S. bankruptcy laws, debt is paid before equity when a company is liquidated.

This became a big issue as the coronavirus pandemic effectively bulldozed its way through a huge chunk of debt-laden businesses. Companies like 24 Hour Fitness, Borden Dairy, Chesapeake Energy, and Hertz filed for bankruptcy amid the pandemic.

Those investors were left empty handed as the companies paid off employees, vendors, and other creditors before equity holders.

While taking on debt during the pandemic helped many companies stay afloat, it also bottlenecks their long-term growth as they must pay that debt down with interest.

Of course, there are other exit strategies that can benefit investors, such as Google’s acquisition of Fitbit. The company trades for a fraction of its 2016 IPO price, despite its name being synonymous with fitness trackers.

A European Union (EU) commission cleared Google’s purchase that gave Fitbit its biggest stock boost since going public. If and when approved by the U.S., the acquisition will roll Fitbit’s shareholders into Alphabet’s.

The vast difference in these two stories highlights the different endings an investor can experience with their money. 

How Do P/E Ratios Help Investors Value Stocks?

P/E ratios are a great introduction to understanding a company’s valuation. They can often be high for a high-profile IPO like Snowflake (SNOW) or DoorDash.

However, each of these companies is facing different challenges to their growth, and as explained above, it’s the infrastructure they are building that is ultimately being evaluated.

Sometimes, a high P/E ratio can be a dangerous sign though. GM (GM) and Ford’s P/E ratios are around 20, which makes Tesla’s PE ratio of over 1,000 daunting. But if it does truly revolutionize the electric vehicle industry, it could be worth it.

Famed analyst Gene Munster claims Tesla is way ahead of its competitors on software development and that it’s likely to expand beyond the auto industry, which justifies its valuation.

Investors can’t predict the future though, and sometimes market factors take over a stock’s price.

Does a Stock Split Change Its Value?

A stock split lowers the price of each individual share, but it doesn’t change the company’s market value.

This is because more shares are trading at a proportionately lower value. However, stock splits can change market sentiment and increase trading volumes, which is often beneficial to a company’s value over the longer term.

In fact, there are several factors that can change a company’s value.

What Market Factors Can Affect a Stock’s Price?

When Warren Buffett acquired Berkshire Hathaway (BRK.A), textile manufacturing was shifting to cheaper Chinese imports. This global market change meant Hathaway could no longer compete, and Buffett converted it into a holding company for his more successful investments.

This is why Buffett announced a freeze in buying stocks at the beginning of the coronavirus pandemic. The so-called Oracle of Omaha was hesitant to make any wrong moves during a global pandemic that fundamentally changed everyday life.

COVID-19 shut down tourism, retail, gyms, live events, and more.

And the economic recovery will be another market-changing event. We already saw signs of it after the election when successful vaccine candidates stifled so-called pandemic stocks while boosting recovery stocks. So what do you look for in a company’s value?

What Do Investors Look for in a Company?

A company cannot be judged by one quarter – it takes growth quarter after quarter, year after year. Both revenue and earnings should trend generally up, even if it is a seasonal business. Predictable revenue streams with growth potential are gold to seasoned investors.

In addition, you want to find a company with low debt and high liquidity to keep expenses in check. Good investors wait patiently for a good deal, so don’t be afraid to watch the market for a while before you put your money in.

And be sure to perform due diligence to fully understand how a company is performing against the market and its competition.

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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.