When Is A Stock Overvalued?
Simple Metrics Investors Can Rely On And Avoid Costly Mistakes
How can we see if a stock is overvalued? It doesn’t need to be complex and investors can do a great job by tracking the evolution of a stock’s Price To Earnings ratio (for profitable companies) or Enterprise Value To Sales ratio (for growing companies).
Investors should look at these ratios in 2 dimensions:
Start by looking at the evolution of the ratio over time. A rising ratio may be a good sign as it signals investor confidence in the future. However, this also means that an increasing portion of the business’ future is already priced in. If the ratio is significantly above its historical average, make sure you review why this could be the case:
- Have margins improved?
- Is the business growing faster than usual?
- Has the business disclosed a new strategy?Stand back when growing multiples are only driven by investor optimism or euphoria. It can be very hard to make a buck on irrational optimism.
Compare the stock’s ratio to its peers / sector. Companies in the same sector, with a similar cost structure and comparable growth should trade at more or less the same multiples
- After looking at the Price To Sales ratio, many investors argue that Aterian (previously Mohawk Group Holdings) and Opendoor are cheaply valued
- Yet, investors should not forget that these businesses operate on significantly lower margins than SaaS or other tech businesses
Disclaimer
Please note that this article does not constitute investment advice in any form. This article is not a research report and is not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.
Credits
Photo by Jingming Pan on Unsplash.