A STOCK is overvalued when its price can’t be justified by its fundamentals and earnings outlook.
Overvalued stocks are risky and subject to selloffs. Specifically, stock is overvalued stocks when:
- P/E ratio over 50.
- PEG ratio over 3.
- P/S ratio over 10.
- P/B ratio over 10.
- Price/Free Cash Flow ratio greater than 50.
- D/E ratio high over 0.5.
Let’s discuss the meaning and significance of these ratios.
- P/E Price/Earnings Ratio:
- The price-earnings ratio is the ratio of a company’s stock price to the company’s earnings per share.
- The ratio is used for valuing companies and to find out whether they are undervalued (good) or overvalued (bad).
- PEG Price/Earnings Growth:
- The PEG Ratio is a more accurate measure of value than the P/E ratio.
- Divide the P/E ratio by the anticipated growth rate of a stock.
- PEG Ratio evaluates a company’s value based on both its current earnings and its future growth prospects.
- A PEG less than 1.0 is considered low and indicates that the stock is undervalued (good).
- Anything above 2.0 is frequently considered aggressive (bad).
- P/S Price/Sales Ratio:
- The price-to-sales ratio shows how much investors are willing to pay per dollar of sales for a stock.
- It’s calculated by dividing the stock price by the underlying company’s sales per share.
- A low ratio implies that a stock is undervalued (good), while a high ratio indicates that the stock is overvalued (bad).
- When a company experiences a period of early growth, investors place an unrealistic valuation.
- When the value of the company drops below their expectations, investors panic and sell the stock.
- P/B Price/Book Ratio:
- Comparing its market price to its book value indicates if the stock is underpriced or overpriced.
- Ratio less than one = trading at less than its book value, or stock is undervalued and a good buy.
- Ratio greater than one can be interpreted as being overvalued or relatively expensive.
- It’s better to compare P/B ratios within industries.
- P/CF Price/Cash Flow:
- The cash flow to sales ratio is cash generated by the regular operating activities of a business.
- Divide the share price by the operating cash flow per share
- A low ratio indicates that a company is generating ample cash flow that is not yet properly considered in the current share price (good).
- A high ratio indicates that a company is trading at an overvalued range and is not generating enough cash flow to support the multiple (bad).
- It’s more insightful when it is compared with companies within the same industry.
- D/E Debt To Equity Ratio:
- The debt-to-capital ratio is a measurement of a company’s financial leverage (loans).
- This ratio is used to evaluate a firm’s financial structure and how it is financing operations.
- It focuses on the relationship of debt liabilities as a component of a company’s total capital base.
- Capital includes the company’s debt and shareholders’ equity.
- A low debt to equity ratio implies a more financially stable business (good).
- A high debt-to-capital ratio indicates that it uses debts to finance operations and assets that can lead to danger of selloffs and higher default risk (very bad).
Sample list of overvalued stocks:
- Enphase Energy (ENPH)
- IDEXX Laboratories (IDXX)
- ServiceNow (NOW)
- Square (SQ)
- Tesla (TSLA)
- Amazon (AMZN).
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Victor Santos Sy, MBA. CPA (Retired)
Victor Santos Sy graduated Cum Laude from UE with a BBA and from Indiana State University with an MBA. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation.
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He retired after 50 years of defending taxpayers audited by the IRS, EDD, BOE and other governmental agencies. He published a book on “How to Avoid or Survive IRS Audits” that’s available at Amazon. Readers may email tax questions to firstname.lastname@example.org.