Many investors wonder how they can tell if a stock is overvalued and should not be at the top of their buying list. The price-to-earnings (P/E) ratio, also known as the “earnings multiple,” provides a quick way to gauge a stock’s value, but it doesn’t mean much until you understand how to interpret the result.
High Value Signals
A stock is considered overvalued when its current price does not align with its P/E ratio or earnings expectations. For example, if a stock is priced at 50 times earnings, it is likely overvalued compared to a stock trading at 10 times earnings.
PEG Ratio and PEG Ratio Adjusted for Dividend Earnings
Both the price-to-earnings-to-growth (PEG) ratio and the PEG ratio adjusted for dividend earnings can be useful when trying to determine the true value of a stock. Just be mindful of the rare cases when the rule does not hold true.
Relative Yield of Dividend Earnings
You might find that the current dividend yield of the stock is in the lowest 20% of the overall range over time. There are many reasons this could be the case. It might be that the sector it belongs to is undergoing a significant change, or perhaps the company’s own business practices have been altered. However, the core functions of the company will likely remain stable over time, with a potential range of outcomes. The stock market may be volatile, but the actual business of most companies, over most time frames, is more stable. (At least when considered over complete economic cycles.)
Value Trap
Certain types of companies, such as home builders, automotive manufacturers, and steel mills, have unique characteristics. These companies tend to see sharp declines in profits during downturns. They also experience significant profit increases during growth periods. When this happens, you may be tempted by what appears to be rapid earnings growth and low P/E ratios, and in some cases, large payouts.
Comparison with Treasury Bond Yield
The dividend yield of the stock, compared to the yield of a Treasury bond, can provide another indicator of its value. Whenever the yield of a Treasury bond exceeds the dividend yield by 3:1, be cautious. You can find this out using the following formula: (2 ÷ 30-year Treasury yield) ÷ fully diluted EPS.
Economic Cycles
Don’t forget to adjust value for economic cycles as well. For example, during the recession of 2001, many great companies had significant one-time discounts that led to very low profits and very high P/E ratios. Companies grew more steadily in the following years because, in most cases, no long-term damage was inflicted on their core functions.
Conclusion
It is one thing to hold something that might be 25% higher than your best guess at value. It is another to hold stocks that are so overvalued that they make no sense in a rational market. One danger is the desire to trade frequently. When you own shares in a great company, which often enjoys a high return on equity, a high return on assets, and a high return on invested capital, it is more likely that the value of the stock will grow over time.
Frequently Asked Questions (FAQs)
What does a negative PEG ratio mean for a stock?
A negative PEG ratio can mean either that the company’s current income is negative (the company is operating at a loss) or that it expects negative growth in earnings in the upcoming quarters.
How
Can value investors find a company’s financial data?
Many companies may have an investor relations section on their website. There, you will find financial data, shareholder letters, and information about dividends. You can also use EDGAR, which is the Securities and Exchange Commission’s tool for filing financial data for public companies.
Source: https://www.thebalancemoney.com/how-to-tell-when-a-stock-is-overvalued-357147
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