OVERVALUED STOCKS
Overvalued shares or stocks are those securities whose current prices don't do justice to the earning potential and have a PE ratio which is inflated as compared to its fundamental value and hence, analysts expect its share price to fall drastically in a market with due course of time.
UNDERSTANDING
The most important thing about overvalued shares is the PE ratio, which signifies the earning of the entity against the price of the share. It may be one that generally trades at a rate that trades at a higher PE when compared to its peer group.
We have 2 contrast theories in the stock market regarding the concept of undervalued and overvalued stocks. One is based on the perfect efficient market concept where few analysts believe that fundamental analysis of a share is vain because there can’t be an undervalued or overvalued stock as the market has full knowledge about the trade and the stocks involved in the trade. On the other side, there is a group of fundamental analysts who firmly believe that there are chances to lose or make money in the market only based on the concept of undervaluation and overvaluation and that overvalued and undervalued stocks also exist in the stock market.
Overvalued stocks are the major instruments used by traders to cover their short positions, which signifies them selling their shares to again purchase them back when the price dips to the standard of market. Traders may also deal in shares which may be an outcome of premium paid because of the superior management or branch name associated with the company, which sharply result in increased value of the share when compared to peer stocks operating in the same industry.
IDENTIFYING OVERVALUED STOCKS
The most common way to detect such shares being traded in the market is by doing an earning analysis by using the PE ratio. This is a dimension that brings about a comparison between by taking the most important factor, which is the value of the stock in market. The most important thing here to watch is the earnings of the company against the price of the stock. An overvalued stock may be one that is usually traded at a rate which is much higher than the companies of the same peer group.
Investors making comparisons can create a bucket where they take some stocks trading at a high PE ratio, and along with it, take some shares of companies operating in the same industry with low PE ratio and see how much variance is in PE.
For instance, we can talk about a share that is being traded at Rs 180 with an EPS of Rs 6. Hence we see the PE ratio here is 180/6 i.e. 30. Therefore the share is being traded in the market at 30 times more than what it is actually earning.
UNDERVALUED VS OVERVALUED STOCKS
Overvalued stocks are stocks whose current market price does not justify its potential of earnings. Basically it has an overrated PE ratio and investors expect the price to fall sharply in the market with due course of time. They are the ones which are a result of logic-less decision making or emotional trading, which may inflated the share price in the market and people just like herd mentality may fall for it but eventually realise that there is no value when it comes to the stock.
Undervalued stocks on the other side are just the opposite of overvalued stocks, It usually sets at a rate which is lower when compared to its book value or intrinsic value. To calculate the intrinsic value, you can refer to the financial statements of the company and cash flow along with other fundamentals like ROA, capital management etc. These stocks are excellent buys in the long term conditional to that the company is performing and overall fundamentals are solid.
THE CRUX
Undervalued or overvalued stocks can be found by the prime dimensions which is called the PE ratio. But there is no fixed value again. A share with a high PE of 50 may still be undervalued as it all depends on the earnings. It is thus solely based on the investor to decide whether the stock is under or overvalued and invest accordingly.
