How to find overvalued stocks

Understanding overvalued stocks

Definition of overvalued stocks

Overvalued stocks are those that trade at a price higher than their ‘fair’ or intrinsic value. This means that the market has priced it above what the company’s actual financial performance or fundamentals would justify. For example, if a company’s stock is trading at $50 but its fundamentals suggest it’s worth only $30, the stock may be considered overvalued.

Many investors avoid purchasing overvalued stocks because there's a chance the market will correct to reflect the stock’s fair value, leading to losses. But some traders specifically seek out overvalued stocks to short sell (bet that the price will fall).

Reasons why stocks become overvalued

Some reasons why stocks can become overvalued include:

• Market speculation: Stock prices can rise quickly due to hype, FOMO (fear of missing out), or emotional trading
• Media coverage: Positive news stories can temporarily inflate stock prices beyond the company’s actual value
• Cyclical momentum: Some industries experience seasonal or cyclical booms that can push up prices temporarily (e.g. retail during holidays)
• Mismatch between earnings and price: If a company’s earnings decline or fall short of expectations, but its stock price doesn’t adjust downward, its stocks could be considered overvalued.

Identifying overvalued stocks using ratios

So, how can you tell if a stock is overvalued? Below are some financial ratios that can help reveal whether a company’s stock’s price aligns with its intrinsic value.

Price-to-earnings ratio (P/E)

The price-to-earnings (P/E) ratio tells investors how much they’d have to spend to make $1 in profit. It’s calculated as:

P/E = Stock Price / Earnings per Share (EPS)

For example, if a stock trades at $100 and has earnings per share of $0.50, the P/E ratio is 200 ($100/$0.50). This means that investors are willing to pay $200 for each $1 of the company's earnings.

A high P/E ratio could mean that a stock is overpriced relative to its earnings potential, especially when compared with similar companies in the same industry.

Price/earnings-to-growth ratio (PEG)

The price/earnings-to-growth (PEG) ratio adjusts the P/E ratio by factoring in expected earnings growth. It’s calculated as:

PEG = P/E Ratio / Annual EPS Growth Rate (%)

For example, if a company has a P/E of 20 and a projected earnings growth rate of 5%, its PEG would be 4. This means investors are paying four times the company’s expected growth. Again, a high PEG ratio coupled with below average earnings can indicate that a stock is potentially overvalued relative to its future growth potential.

Price-to-book ratio (P/B)

The price-to-book (P/B) ratio compares a company’s market price to its book value (the value of all assets minus liabilities). It’s calculated as:

P/B = Market Price per Share / Book Value per Share

For example, if a company has a book value of $40 per share and its stock trades at $60, the P/B ratio is 1.5 ($60/$40). If the P/B ratio is higher than 1, it could indicate an overvalued stock, although it’s important to compare with competitors as P/B ratio can vary widely by industry.

Earnings yield

Earnings yield is essentially the opposite of the P/E ratio. It’s calculated as:

Earnings Yield = Earnings per Share / Market Price per Share

For example, if a stock has earnings of $20 and trades at $80, the earnings yield is 25%. Low earnings yield may indicate that a stock is overpriced. Some traders consider a stock to be overvalued if its earnings yield is lower than the Treasury yield (interest rate the U.S. government pays investors who hold bonds).

Debt-to-equity ratio (D/E)

The debt-to-equity (D/E) ratio shows how much debt a company has relative to its shareholder equity. It’s calculated as:

D/E = Total Liabilities / Total Shareholder Equity

For example, if a company has $300 million in debt and $1 billion in equity, its D/E ratio would be 0.3. This means there’s $0.30 of debt for every $1 of equity.

A high D/E ratio suggests that a company is relying too heavily on borrowed money to finance its operations, which could potentially signal an overvalued stock. That said, a company’s D/E ratio should always be compared to its competitors because what’s considered a ‘good’ D/E ratio can vary between industries.

Return on equity (ROE)

Return on equity measures how well a company is using shareholder equity to generate profit. It’s calculated as:

ROE = Net Income / Shareholder Equity

For example, if a company earns $200 million in net income and has $240 million in equity, its ROE is 83%. A low ROE could mean that a company isn't using its capital efficiently, potentially signalling an overvalued stock.

Current ratio

Current ratio measures a company’s ability to pay off its short-term liabilities using its current assets. It’s calculated as:

Current Ratio = Current Assets / Current Liabilities

For example, if a company has $2.2 billion in assets and $2 billion in liabilities, its current ratio would be 1.1. If the current ratio is over 1, it means that a company’s assets are worth more than its liabilities. In other words, a company is able to meet its short-term liabilities. Sometimes, a higher current ratio can lead to an overvalued stock if investors overestimate a company’s financial strength.

Analysing market valuation models

The ratios we’ve outlined above can help you identify whether or not a stock is overvalued, but what about the market as a whole? That’s where market valuation models come in.

Buffett Indicator

The Buffet Indicator, named after legendary investor Warren Buffett, is used to gauge whether the overall stock market is overvalued, undervalued, or fairly valued. It’s calculated by dividing a country’s total market capitalisation by its gross domestic product (GDP).

Buffett Indicator = Total Market Capitalisation / GDP

The market is considered fair value if the ratio is near 100%. At the time of writing, the Buffet Indicator for the United States sits at 200%, about 1.8 standard deviations above the long-term trends. This suggests that the market is overvalued.

Price/earnings model

The P/E ratio valuation model takes the P/E ratio and applies it to the entire market. To do this, the price of every share in the S&P 500 is added up and compared to the sum of all earnings-per-share generated by those companies. The result is the P/E ratio of the US stock market.

The current S&P 500 10-year P/E ratio is 34.4, which is 67.5% above the long-term average of 20.5. This signals that the U.S. market is currently overvalued.

Interest rate model

The interest rate model looks at whether the stock market is fairly valued when considering current interest rates. The idea is that stock markets and interest rates (or bond markets) have an inverse correlation, so when interest rates are high, stocks are low and vice versa.

At the time of writing the interest rate model shows that the U.S. stock market is overvalued relative to a normal interest rate environment.

S&P 500 mean reversion

The S&P 500 mean reversion model compares the current S&P 500 level to its long-term exponential growth trend, assuming that markets revert to the mean over time.

At the time of writing, the S&P 500 is trading 60% above its modern-era historical trend value, suggesting an overvalued market.

Earnings yield gap

The earnings yield gap compares the earning yield of stocks to the yield on government bonds, usually the 10-year U.S. Treasury. It helps investors determine which asset class offers better value.

It’s calculated as:

Earnings Yield Gap = (S&P 500 Earnings / S&P 500 Price) - U.S. 10-Year Treasury Rate

At the time of writing, the earnings yield gap is -0.21%. This is 0.22 standard deviations below the historical average, suggesting that stocks are currently fairly valued relative to bonds.

Market sentiment indicators

Market sentiment indicators measure whether investors are collectively optimistic or pessimistic about the market.

Margin debt

Margin debt is money investors borrow to buy stocks (i.e. using leverage to amplify their positions). The idea is that investors will borrow money to invest in stocks when they feel optimistic about the market, and they’ll settle those debts when they feel pessimistic about the market.

In the U.S., total margin debt increased by 0.25% over the last year, suggesting that market sentiment is currently neutral.

Junk bond spreads

Junk bonds are non-investment grade bonds that have higher default risk, and higher returns to compensate for the risk. The junk bond spread compares the difference between junk bond yields and 'risk-free' U.S. Treasury bond yields.

When the spread is high, it suggests pessimistic market sentiment as investors demand higher premiums to invest in riskier bonds. When the spread is low, it suggests optimistic market sentiment with investors willing to take on risk for relatively little return. The current junk bond spread suggests that market sentiment is neutral.

VIX fear index

The VIX, or Volatility Index, measures how much volatility is expected in the S&P 500 over the next 30 days. It's often used to measure investor sentiment and market risk. A high VIX means investors expect volatility over the next month, while a low VIX means they're expecting stability.

Trading overvalued stocks

Now that you know how to identify overvalued stocks, let’s talk about how you can trade them. The main strategy when trading overvalued stocks is short selling.

How to trade overvalued stocks: going short

Short selling, or ‘going short’, involves borrowing shares of a stock and selling them at the current market price, with the intention of buying them back later at a lower price.

Here’s how it works step-by-step:

1. You identify a stock you believe is overvalued and likely to fall in price
2. You borrow shares and sell them immediately at the current (higher) price
3. If the stock’s price drops, you buy it back at the lower price, return the shares to the lender, and pocket the difference as profit.

For example, if you shorted a stock at $120 and bought it back at $100, you’ve made a $20 profit per share (excluding fees or interest). But if the stock was to rise to $140, you’d be losing $20 per share when buying it back.

There are both risks and rewards when it comes to short selling. If your prediction is correct and the share prices go down, you can make money buying them back at a lower price. But if the share prices go up, your potential losses are theoretically unlimited. If you're trading on leverage, your losses would be magnified.

Because of this risk, it’s essential to use risk management strategies when short selling. This could include:

• Setting stop-loss orders to limit losses if the stock price rises beyond a certain point
• Avoiding excessive leverage
• Only shorting stocks that show clear signs of overvaluation and downward momentum.

Using ratios to determine if a stock is overvalued should not be solely relied upon but should be used as part of a larger analysis of stocks or markets.

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