Nowadays people are constantly looking for different ways to know overvalued and undervalued stocks it is recognized as a smart investing tactic of the stock market where it is important to find the stocks that are undervalued and sometimes overvalued. However, stock prices aren’t exactly overvalued or undervalued. Your definition of value may not be the same as someone else’s definition of value. For example, Flipkart which may be making big losses still sold in insane valuation. So, how would you justify this? The answer is you can’t. But, let’s not talk about the Flipkart. It is a relative terminology. An investor is selling a stock at a price where another investor is buying it. So, the person who is selling it believes that stock is overvalued so he is happy to sell it. But, on the other hand, a buyer is ready to buy it at that price and believes there is still a lot of potential in that stock. So, what would you say to this one?
But, we shouldn’t just jump to the conclusions. Because even if it is a relative term, it is important to know “how one can know if a stock is overvalued or undervalued?” Well, there are different ways to know about it.
Let’s find out.
How to know if a stock is overvalued or undervalued?
There are several ways to know if a stock is overvalued or undervalued which are as follows:
1. Price-Earnings Ratio (P/E Ratio) & Earnings Yield (E/P)
It is a ratio of valuing a company which calculated by the measure of its current share price relative to its earnings per share (EPS).
P/E ratio = Current share price / earnings per share
It is also known as price multiple because it shows how much an investor is willing to pay per rupee of earnings. For example, if a company was currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay Rs. 20 for Rs. 1 of current earnings.
It is the most popular method of stock valuation. But, P/E should always be looked with respect to the growth, margin, and brand wealth because of a stock at P/E of 10 shouldn’t be compared with a stock at P/E of 20. Of course, at the index level low, P/E may indicate the undervaluation and high P/E can be seen as overvaluation. But, as we said, it is just a relative term.
For example, Maruti has high P/E just because of sustained growth momentum month-after-month. On the other hand, Hindustan Unilever and Britannia are one of those who has a high P/E ratio due to strong brand value.
Another way to gauge the stock overvaluation and undervaluation is the earnings yield (E/P). If the earnings yield is lower than the yield of debt, then it makes a case of equity overvaluation.
2. Price to Book Value Ratio (P/B Ratio)
Price to book value ratio is a very handy approach to finding undervalued and overvalued stock. It is also used to evaluate a company for valuation. Price-to-book value (P/B) ratio is the ratio of the market value of a company’s shares (share price) over its book value of equity. By book value, we mean the value expressed on the balance sheet.
P/B Ratio = Stock Price / [total assets – liabilities]
But, you need to understand that P/B ratio is no magical formula. It is more selective and industry-specific measure. This ratio generally uses in capital-intensive businesses, such as financial business, energy or transportation firms. Basically with plenty of assets on the books. Normally, a bank with a low P/B ratio is considered undervalued.
3. EV/EBITDA as a Valuation Measure
EBITDA is a valuation measure to gauge stock undervaluation when a company is being merged or acquired. It works best in case of M&A situations. Enterprise multiple is a ratio of enterprise value (EV) and EBITDA which determine the value of a company. It a valuation measure which usually works in the case of power companies, internet companies, and telecom companies. Because these are the sectors which usually take years to turn around and make profits. During that time, P/E ratio is not much of any use.
Enterprise Multiple = Enterprise Value (EV) / EBITDA
Here, the enterprise value is the market value of a company less its external debt; however, the EBITDA is the earnings before interest, taxes, depreciation, and amortization which are the measure of company’s profit independent of the capital structure.
Lower the Enterprise multiple values is, the stock is considered to be relatively undervalued.
4. Dividend Yield
The dividend yield is another way to measure if the stock is undervalued or overvalued but to an extent. It is because the dividend yield is the dividend per share divided by the price per share.
Dividend Yield = Dividend per share / Price per share
To best understand this, let’s assume if a stock quoting at Rs. 100 pays Rs. 5 as a dividend, then the dividend yield is 5%.
Generally, if the dividend yield is higher, lower is the valuation and vice versa. But, that doesn’t work out very well because stock markets look forward to the high-dividend-paying companies.
What market wants is the consistent growth hence; the high dividend yield is not seen as too positive. If the dividend yield is low then there is the possibility of its increase over time. A straightforward high dividend yield creates doubts in the mind of investors who hesitate to invest in such high-dividend yield providing companies.
5. The Margin of Safety of the Stock
It is rather a new way to gauge the valuation of a company and to know if the stock is undervalued or overvalued. It comes from Warren’s Buffettology that has gained a lot of popularity in recent times. It is defined as the gap between the actual intrinsic value of a stock and the actual market price.
So, lower the margin of safety, more undervalued is the stock.
Hope, this article helped you in a way you expected it to be. Nevertheless, if you have any query or would like to add something up then don’t forget to mention in the comment section below.
Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.