Investing > Complete Guide to Overvalued Stock

Complete Guide to Overvalued Stock

You might think that a disparity in real, intrinsic value and stock price might seem like a bad thing—but you’d be very, very wrong.

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Updated January 09, 2022

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Would you like to pay more money for a stock than it is actually worth?

That’s a trick question – of course, you wouldn’t. No one in their right mind would. But this does happen relatively often –  the fact is that stock prices do not necessarily reflect the fair value of the underlying companies.

Here is where the concept of undervalued and overvalued stocks comes into play. With undervalued stocks, things are simple – if you have the time to wait for a price correction, they’re a great avenue for long-term investing. ⏲

But what do we do with overvalued stocks? Do we simply avoid them, hoping to prevent any possible missteps?

No, we don’t because even overvalued stocks offer plenty of opportunities to secure profits – provided you know how to spot them and trade them. It requires a bit of know-how, but that’s why we’re here – we’re going to explain how you can find these stocks, and how you can trade them.

There’s a simple factoid that we have to get out of the way – there’s very little chance that you’re going to be able to steer clear of overvalued stocks. The stock market, as a whole, has been a bit overvalued in the past few years. We’ll go into more detail down below, but the fact remains – overvalued stock is something that you’re going to run into, sooner or later. 🤔

Before we move on to the meat of the matter, let’s get some things straight – trading overvalued stocks isn’t simple. It requires a rock-solid understanding of fundamental analysis, knowing how to handle plenty of ratios and metrics and a decent grasp of derivatives. That’s a tall order – but if you feel like you’re up to the challenge, you’ll be able to make money even in the midst of downturns that will sweep away your competition.

What you’ll learn
  • What is an "Overvalued" Stock?
  • How to Tell If a Stock is Overvalued
  • Trading Overvalued Stocks
  • Example of Overvalued Stock
  • What is an Overvalued Stock Market?
  • Determining Overvaluation
  • Conclusion
  • Get Started with a Stock Broker

What Does “Overvalued” Mean for Stocks, Exactly? 👨‍🏫

To put in the simplest possible terms, an overvalued stock is a stock that is trading at a price that is unreasonable. In other words, paying that amount of money for a stock is unjustified – the stock’s long-term or short-term prospects, earnings outlooks, revenue, or other factors don’t match up with the price.

When a stock is overvalued, that’s a sign of investor confidence – but if the real factors that contribute to the success of a business don’t catch up, eventually, people won’t be as prepared to risk their hard-earned money by investing in that stock. As a result, they will sell, and the price will drop – and that drop is usually sudden and large.

Even if that doesn’t happen (although it usually does, sooner or later), eventually, investors will realize that a stock is overvalued – in other words, they’ll come to see that they are exposing themselves to too much risk. Once that happens, they’ll look for alternative investments: In the best-case scenario, the stock price will plateau, and trading volume will dry up for the overvalued stock.

In short – if a stock is overvalued, you’re going to be overpaying if you decide to buy it – and that’s something you always want to avoid.

How to Tell If a Stock is Overvalued 👷‍♂️

Thankfully, there are a variety of ways in which you can tell if a stock is overvalued. Most of them rely on ratios, but the math isn’t too hard – and the information that you’ll need to calculate these ratios is widely available. Most of the leading online brokerages offer fundamental data – but even if your brokerage of choice is lacking in this regard, it shouldn’t be too hard to find the information you need.

Analyze the Fundamentals 📝

Fundamental analysis is probably a term that you’ve come across already – and it’s no wonder, seeing as how it’s an essential step for analyzing stocks if you are looking to invest in the long term. 

If you’re not familiar with this term, fundamental analysis encompasses going through a company’s financial statements. These include balance sheets, income statements, cash flow statements, debt to equity ratios, as well as other metrics and qualitative factors that determine a stock’s overall health.

Once you’ve mastered the art of fundamental analysis, you’ll have a much easier time of calculating a stock’s fair or intrinsic value – and once that’s taken care of, comparing the intrinsic value to the stock’s current price is a piece of cake.

We’re going to cover the specific ratios and metrics that you should pay attention to in the next section, but fundamental analysis is an essential skill (some would say fundamental 😬) when it comes to investing – and there’s a lot to learn there. If you truly want to master that skill (and you should), don’t limit yourself to piecemeal knowledge – go above and beyond.

Pay Attention to These Ratios and Metrics 📃

When it comes to ratios and metrics, the best way to use them is comparatively – when you’re narrowing down your search of what to invest in, compare companies through the lens of these factors.

A stock’s P/E ratio or price-to-earnings ratio measures stock price and earnings per share or EPS. A high P/E ratio is a sign that a company is overvalued – if you’re presented with a choice between two stocks, with everything else being equal – pick the one with the lower P/E ratio.

The price/earnings-to-growth or PEG ratio is a slightly more advanced formula – it depends in large part on the P/E ratio. To get this ratio, we take a stock’s P/E ratio and divide it by the growth rate in a specific period of time. With the PEG ratio, a rule of thumb is in place – the lower, the better. Anything less than 1 is great, and everything near or above 2 is likely overvalued.

The price-to-book or P/B ratio is calculated by taking the stock price and dividing it by book value. Just like with PEG, the lower the P/B ratio, the better – and you should always contrast a company’s P/B ratio with that of its competitors.

Take a Look at Dividend Yield ➗

Dividends allow investors to secure a small, yet stable source of passive income without parting from the benefits of capital appreciation. Although they can’t be used on their own, in combination with the other factors that we’ve talked about, dividends can give you an idea of how a stock is doing.

Now, obviously – this only holds true for stocks that pay dividends. If a company has cut dividends, it is most likely a sign that it is in trouble – which signals a price correction waiting to happen.

Trading Overvalued Stocks 🤝

So, apart from avoiding overvalued stocks, is there a way to actually profit off of the fact that a stock is overvalued? Of course, there is – in fact, there are a couple of ways to do so. 

Keep in mind, however, that all of these methods are risky – some involve derivatives and other complex financial instruments. Generally speaking, trading overvalued stocks takes a lot of experience. We wouldn’t recommend trying this if you don’t have the basics of stock trading down to an art – and even then, we’d caution you to use a demo account to test and backtest strategies before embarking on live trading.

Short Selling 📈

Let’s begin with the most significant method – short selling. You might have come across this term before – the recent GME short-selling squeeze put short selling in quite an unexpected spotlight. So, how does it work?

To put it simply, when you short sell a security, you borrow it and immediately sell it. Due to the terms of short selling, you have to return the stock to its previous owner in a specified timeframe – but if your prediction was correct, and the price of the overvalued stock drops – you’ve made a profitable move.

Let’s use a hypothetical example. You borrow stock from another trader at a time when it’s trading at $20. You immediately sell it – and in a few days, the price drops to $14. At that point, you can buy it for $14, give it back to the lender – and pocket the $6 difference as pure profit. Multiply that by a 100 – say that you’ve borrowed 100 shares – and now you’ve made $600.

Short selling is a great way to acquire gains – but it requires skill, patience, and plenty of practice, as this is a risky trading method. The potential downside with short-selling is unlimited – if the stock price rises, you’ll accrue losses. And as the recent GMA saga proves, stock prices can rise to ridiculous lengths on a moment’s notice.

Options 📊

Apart from short selling, investors can also trade overvalued stocks by using options – specifically, put options. Options are derivatives, which means that they are complex financial instruments and that their worth is based upon the worth of an underlying asset – in this case, a stock.

Options give you, the investor, the ability (but not the obligation) to buy or sell a stock at a predetermined price by a predetermined date. In essence – if you think you know what a stock’s price will be by a particular date in the future, options allow you to profit off of that price movement.

Put options give you the right to sell a stock at a predetermined price. If you think a stock’s price is overvalued and is therefore going to drop, purchasing a put option might be a good choice. 

Let’s use an example – a stock is trading at $45, but you consider it to be overvalued. You buy a put option that gives you the right to sell the stock for $42 – and the stock price drops to $38 in the next couple of days. This situation would give you two choices – secure a profit of $4 per share if you own the stock, or trade the actual options contract for profit.

Although they are risky and incredibly short-term, binary options offer another method by which you can trade overvalued stocks. Specifically, we’re referring to binary puts – binary options that give you a payoff if the price of the underlying stock drops under its current price. There are quite a few types of binary options, such as high/low, no-touch, and range binary options – but to trade them effectively, you’ll need a rock-solid binary options trading strategy.

Overvalued Stock Example 📙

To better illustrate everything that we’ve been talking about, let’s use an example. But unlike the rest of the examples in this guide, this one isn’t hypothetical – this actually happened. 

Teleflex (TFX) is a provider of medical tools. It employs more than 12,000 people, has annual revenue in excess of $2.4 billion, and has been listed on the S&P 500 since 2019. Sounds good, right?

Unfortunately, in this case, it wasn’t that good – due to a variety of factors, including unfounded optimism for medical stocks in the wake of COVID-19, Teleflex stock surged without anything to back it up. Of course, the ratios and metrics reflected this – and once investors caught on to the fact that the stock was overvalued, there was a dramatic price correction.

overvalued stock example
In 2021, the S&P 500 vastly outperformed TFX when investors started selling off the stock that seemed overvalued. Image by TradingView.

In the span of just five days, from July 14th to July 19th in 2021, the stock price of Teleflex dropped from $417 to $375. Obviously, if you were holding shares during that week, you had a tough time – but if you had paid attention and decided to short the stock, or invest in put options, you could have ended up making a lot of money on this overvalued stock.

How to Tell If the Stock Market is Overvalued? 📚

In the same way that a particular stock can be overvalued, the entire stock market can be overvalued. This doesn’t just increase the odds of running into an overvalued stock – everything in the market is connected, and investor sentiment usually resembles groupthink to a large degree.

If the stock market is overvalued (and spoiler alert, it often is), this is a troubling sign – it points to an underlying problem in the economy and can signal large, market-wide price corrections, future recessions, bubbles, crashes, and plenty of other large-scale situations that spell trouble. Let’s take a look at how you can determine if the market itself is overvalued – and if so, how overvalued it is.

Shiller CAPE Ratio 🧮

The Shiller Cape (a.k.a Shiller PE) ratio is a valuation measure pioneered by Yale University professor Robert Shiller, which is used to determine if the market as a whole is overvalued or undervalued. In the past few decades, it has proved to be one of the most reliable methods of answering that question.

The formula of the CAPE ratio is rather simple – share price divided by 10-year average, inflation-adjusted earnings. The CAPE ratio can also be used for individual businesses, and it gives you another lens through which you can contrast and compare two companies – but it can also be applied to indices, such as the S&P 500 or the Wilshire 5000.

Shiller_PE_ratio_from_1870_to_2021
A high Shiller PE ratio has historically preceeded major price corrections on the stock market.  

The average CAPE ratio for the S&P 500 sits at around 16.9. As of November 2021, it is at 38.70 – and it hadn’t dipped below 34 since the beginning of 2021. The ratio is incredibly high – and the last couple of times this has happened, disaster was soon to follow. Just to be clear – the last few instances of the ratio being this high were 1929, 1999, and immediately preceding the 2008 financial crisis.

The Buffet Indicator 🧐

The Buffet Indicator (you’ll never guess who it was named after 👴) is a metric that compares the market cap of the entire stock market with the GDP of the United States. When we’re talking about the stock market, we usually use the S&P 500 index. But for the Buffet Indicator, we need an overview of the entire market, so we’ll be using the much-less talked about Wilshire 5000 Total Market Index.

Although you’ve just witnessed a ton of complex-sounding financial terms, the Buffet indicator is actually rather simple. To get what we need, we simply take the value of the U.S. securities market and divide it by annualized GDP, then multiply by 100 in order to get a percentage.

We’ll be using the latest available data as of the time of writing. As of November 2021, the calculation would look like this: ($51.1 trillion / $23.7 trillion)  x 100 = 2.156 x 100 = 215.6%.

So, what does this result tell us? Things are bad. This ratio is well above the historical average – not only is the market overvalued, but it is also significantly overvalued.

Buffet Indicator
In late 2021, the Buffet indicator had reached its highest level in history up to that point. Image by TradingView.

Moreover, the previous two times the Buffet Indicator looked as it does in 2020 was right around the tech bubble… and the 2008 financial crisis. Now, not every case of the market cap exceeding GDP is cause for concern – but a wide disconnect as this one has always warranted concern.

Interest Rates 📉

This won’t come as a surprise to anyone – just as they affect the rest of the economy, interest rates also have a huge effect on whether or not the stock market, as a whole, is overvalued. The reason for that? Government bonds.

Government bonds are held to be the most secure way to secure a profit – and for good reason, as data supports that claim. But safest does not equal most profitable – bond yields are generally low.

And when interest rates are low, borrowing money is easy – meaning that investing in the stock market is easy. These factors, when combined, lead to a simple conclusion – bonds aren’t as attractive any more.

Seeing as how stocks are more attractive in those conditions, people rush into the market, and this drives prices up. It comes as no surprise that earnings per share can’t match up to that growth – so stocks become less attractive. 

dropping federal interest rates
The bull markets from the late 1970s onwards were accompanied by dropping federal interest rates. Image by TradingView.

If, at that moment, interest rates change, and bond yields surpass the EPS of the stock market, you can guess what’s around the corner – people will sell off stocks, move their money into the safer, more profitable investment vehicles like bonds and gold, and stock prices will drop all around. And, just so you have a point of reference – as of 2020, interest rates have been dropping to historic lows.

Tips for Checking if a Stock is Overvalued 👨‍🔧

We’ve covered the nitty-gritty details of how you can see if a stock is overvalued. Most of those steps include fundamental analysis, analyzing financial statements, and plenty of math and checking ratios.

That’s all well and good – in fact, it’s necessary – but you can increase the odds of successfully finding an overvalued stock if you incorporate a couple more steps into your overall analysis. In this section, we’re going to cover several simple, actionable tips that allow you to confirm if you’ve struck gold, so to speak.

Take a Look at Treasury Bond Yields 🕵️‍♂️

We’ve already discussed treasury bond yields in relation to interest rates in an earlier section. However, we look at them from the lens of the overall market – but you can also use treasury bond yields to see if a particular stock is overvalued.

The general rule of thumb is that if a stock’s earnings yield is three times lower than a treasury bond yield, things have already gotten out of hand – there’s a large disconnect between intrinsic value and stock price, and the stock in question is definitely overvalued. 

If that turns out to be the case, you should sell your investments in that stock before accruing a loss – or be prepared to utilize short selling, puts, or other methods of profiting from declining stock prices.

Economic Cycles 🎛

Whenever you’re looking at a particular stock, you also have to figure in the big picture. Economic cycles (whether or not the economy is expanding or experiencing a recession) can skew the meanings of plenty of the metrics that we rely on when dealing with overvalued stocks.

Recessions often lead to stimulus packages, write-offs, and other economic measures that can easily lead to things such as high P/E ratios. This, for example, is something that would otherwise suggest that a stock is overvalued, but that doesn’t hold true in extraordinary circumstances – to invest in times of recession, you need to ascertain whether a business’s long-term prospects have been harmed, independently of metrics.

Don’t Fall Into a Value Trap 🚧

Value traps are a particularly tricky problem – it’s very easy to be misled and fall for them. In essence, a value trap is a stock that doesn’t seem to be overvalued. In fact, it seems to be quite undervalued. However, in spite of the metrics, the business in question has bad long-term prospects – the already low stock price will continue to plummet, causing you to lose money if you invest.

If you find a stock that seems quite undervalued, take a closer look at the fundamentals. Is the company’s cash flow appropriate? Are the trading volume and stock float healthy? Is there another company in the industry or sector that will dislodge this business from its position, or to put it in simple terms, is the company losing market share?

All of what we’ve talked about in this section falls under the term due diligence – and although it isn’t all too well defined, due diligence means getting a detailed, holistic picture of how a business is doing. It isn’t a simple matter of going through predetermined motions.

Every business is unique, but as you gain more experience, you’ll learn how to figure out if a business is healthy by factoring in various metrics and factors – some of which are qualitative, and others quantitative.

Look for Context (GME and TESLA) 🔍

The stock market isn’t a guessing game. Rational methods, such as analyzing ratios and metrics will always provide you with actionable data – but that won’t give you the entire picture. The fact of the matter is, while cold, hard data is great for analysis, it still isn’t enough to predict how the market will act.

Nothing happens in a vacuum. Even if a stock is showing all the telltale signs of being overvalued, this doesn’t have to mean that the stock’s price is due for a correction any time soon – or at all, for that matter.

We’re going to use the two most obvious examples of the past few years – Tesla (TSLA) and Gamestop (GME). Tesla is pretty much constantly in the news cycle – either because of its innovative technologies or because of its founder and CEO’s sometimes wacky antics. GME, on the other hand, is the most publicized case of a short squeeze in the past decade.

Both Tesla and Gamestop are overvalued stocks if you look at the data. You would expect then, that the stock price of these companies would fall, or at least stop growing – but that isn’t the case. In fact, Tesla has experienced tremendous growth despite its unideal financial metrics – and it has been “overvalued” in all that time.

Investor sentiment matters. Even though the stock is overpriced now, investors are confident that the capital appreciation that is going to occur in the years to come will more than make up for it. 

Conclusion 🚩

Congratulations on making it to the end of this guide – and thank you for taking the time out to learn a bit about this topic with us. At first glance, it might appear as if an overvalued stock is simply a danger to be avoided – but, provided you know what steps to take, it can also be a great opportunity to make money.

Overvalued stocks are, for better or worse, a very common occurrence nowadays. Successfully trading them is a skill of its own – but, we believe that if you put in the effort to master that skill, you’ll be a much more well-rounded (and successful) investor.

Overvalued Stock: FAQs

  • Are Overvalued Stocks Good or Bad?

    Overvalued stocks are not necessarily good or bad. Although they will most likely see a correction in price, that doesn’t always happen - and when it does, skilled investors can leverage that fact to secure gains.

  • Should I Buy Overvalued or Undervalued Stocks?

    In general, buying undervalued stocks is the superior approach for long-term investing. However, as is the case with Tesla, some overvalued stocks might still be good long-term prospects, and there are plenty of other ways to profit off of overvalued stocks too.

  • Is it Good to Buy Undervalued Stocks?

    Yes - buying undervalued stocks is one of the cornerstones of value investing, one of the most widespread and reliable methods of long-term investing.

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