Overvalued and Undervalued Stocks

Overvalued and Undervalued Stocks
How to Find Overvalued and Undervalued Stocks

A common maxim in investing is that you should aim to ‘buy low and sell high’. In reality, this is usually done by buying stocks when they are undervalued and selling them when they are overvalued. This is why it is very important to know how to properly value a stock. It is only by determining a stock’s intrinsic or fair value that you will be able to gauge whether it is overvalued or undervalued.

Stock valuation is an important aspect of active investing because it helps investors assign an intrinsic value to a stock. The intrinsic value will then be the reference point that will determine whether any underlying stock should be bought or sold at any given point in time.

Stock valuation is done by assessing the fundamental characteristics of a company’s underlying business. The most common fundamental methods used to establish the intrinsic value of a stock include earnings per share (EPS), discounted cash flow (DCF), and asset-based valuation.

EPS is simply a company’s net profits divided by the number of outstanding shares. EPS is an important metric for stock valuation because it paints a picture of a company’s ability to generate profits for its shareholders. However, EPS is even more solid when a company is compared to its peers in the same industry. A higher EPS will generally mean that a company is able to generate more profits for its shareholders. Nonetheless, EPS also has its limitations, with companies able to distort it by factors such as changing accounting techniques or implementing share buybacks that reduce the number of outstanding shares.

On its part, DCF is used to gauge whether a stock is attractive based on its projected free cash flows in the future. The first step is to estimate all of a company’s future cash flows and then to discount them to determine their respective present values. All the present values are then summed up to establish the intrinsic value of a stock. If the DCF value is higher than the current investment value, then the stock represents a potentially great opportunity.

DCF is considered the best and most accurate way to determine the intrinsic value of a stock because it takes into account a wide range of fundamental business drivers such as growth rate, cost of capital, and even profit reinvestment. The DCF calculating method also factors in the flexible and important aspects such as a change in business strategy. The only downside to DCF is that it is only best suited for long-term investing strategies. As well, there is an element of risk involved when making ‘assumptions’ about future cash flow projections, even though this can be addressed by tweaking the calculating formula.

Asset-based valuation is the most basic way of establishing the intrinsic value of a stock. It simply involves summing up a company’s tangible and intangible assets and then subtracting all of its liabilities. Asset-based valuation, however, does not take into account any growth prospects and often generates lower intrinsic values of companies compared to other methods.

Despite the Efficient Market Hypothesis that suggests stocks will mostly trade at their fair values in exchanges, markets are rarely efficient due to numerous factors such as market psychology, human emotions, information asymmetries, and even low liquidity.

The existence of market inefficiencies makes the case for value investing, where it is possible to pick out stocks that trade below their intrinsic values. The belief is that with time, the market will gradually realize the inefficiency and this will result in profits for value investors. Value investing is inherently different from growth investing, where investors believe that a stock cannot be expensive and will continue to deliver more growth than both the market and its participants expect.

How to Find Undervalued Stocks

Finding undervalued stocks is an important tenet of value investing. The general assumption of fundamental analysis is that markets will tend to correct towards their fair or intrinsic values. This is why it is important to find quality (not necessarily cheap) stocks that have been priced well below their fair market values. There are many reasons why a quality stock can be unfairly priced in the market, such as negative news, company brand recognition, misjudged results, industry developments, and economic cycles.

Here are some of the fundamental metrics to help you identify undervalued stocks:

  • Price-to-earnings ratio (P/E) –
    The P/E ratio is derived by dividing the price per share by the EPS. It essentially depicts the amount of money that can be spent so as to generate $1 in profits. As such, a low P/E ratio can imply that a stock is undervalued.
  • Debt-to-equity ratio (D/E) –
    The D/E ratio is calculated by dividing a company’s total debt by its shareholder equity. In essence, it is a ratio that expresses a company’s financial leverage – how operations are through debt versus its own money. While a high D/E ratio can be a bad indicator, it is always important to view this metric in the context of an entire industry.
  • Return-on-equity ratio (ROE) –
    ROE is calculated by dividing a company’s net income by its shareholder equity. Thus, ROE essentially measures the rate at which a company can generate profits from shareholder investment. The value depicts the return on each $1 that shareholders invest in the company. A high ROE, therefore, implies that a stock is likely undervalued.
  • Price-to-book ratio (P/B) –
    The P/B ratio is calculated by dividing a company’s current stock price by its book value per share. The book value of a company is simply its total assets minus its total liabilities. Thus, the book value per share is the book value divided by the total number of outstanding shares. A low P/B ratio (under 1) implies that a stock is undervalued.

How to Find Overvalued Stocks

Finding overvalued stocks can help investors implement investing strategies such as selling a stock or looking for short trading opportunities in derivatives markets such as CFDs. The general market assumption is that as markets correct towards their intrinsic values, overvalued stocks will see their prices drop. Stocks can be overvalued because of various factors such as a surge in buying activity, positive news, industry developments, and economic cycles.

Here are some of the fundamental metrics to help you identify overvalued stocks:

  • Price-to-earnings ratio (P/E) –
    A high P/E ratio implies that a company spends a lot more so as to generate $1 in profits. This could be a sign that a stock is overvalued.
  • Debt-to-equity ratio (D/E) –
    A high D/E ratio essentially means that a company is highly leveraged financially compared to its peers in the same industry. This could be a strong sign that a stock is overvalued.
  • Return-on-equity ratio (ROE) –
    A low ROE implies that a company generates very little returns from shareholder investment. This means that the underlying stock is likely overvalued.
  • Price-to-book ratio (P/B) –
    A high P/B ratio simply means that a company’s market price is widely diverged from its true book value. This is a sign of an overvalued stock.

Trading Overvalued and Undervalued Stocks in CFD Markets

The CFD market presents a great environment to trade overvalued and undervalued stocks. When you trade CFDs, you do not own the underlying stock, but instead, you can speculate on its price changes. CFDs come with leveraged trading, low trading costs, and traders can buy or sell stocks without any restrictions.

Here are some of the approaches when trading overvalued and undervalued stocks in CFD markets:

  • News Trading –
    Stock CFDs are traded in real-time, which means that incoming news and information regarding underlying stocks can be taken advantage of in real-time.
  • Technical Analysis –
    Various types of technical analysis tools can be used to map out important support and resistance areas where overvalued and undervalued stocks can likely change direction.
  • Innovative Orders –
    CFD traders can utilize innovative order types such as market orders, buy/sell stop and limit pending orders, as well as stop loss and take profit orders to efficiently take advantage of opportunities in their preferred overvalued and undervalued stocks in the market.

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