[COLUMN] How do you know if a stock is overvalued?

A STOCK is overvalued when its price can’t be justified by its fundamentals and earnings outlook.

Overvalued stocks are risky and subject to selloffs. Specifically, stock is overvalued stocks when:

• P/E ratio over 50.
• PEG ratio over 3.
• P/S ratio over 10.
• P/B ratio over 10.
• Price/Free Cash Flow ratio greater than 50.
• D/E ratio high over 0.5.

Let’s discuss the meaning and significance of these ratios.

1. P/E Price/Earnings Ratio:

• The price-earnings ratio is the ratio of a company’s stock price to the company’s earnings per share.
• The ratio is used for valuing companies and to find out whether they are undervalued (good) or overvalued (bad).

2. PEG Price/Earnings Growth:

• The PEG Ratio is a more accurate measure of value than the P/E ratio.
• Divide the P/E ratio by the anticipated growth rate of a stock.
• PEG Ratio evaluates a company’s value based on both its current earnings and its future growth prospects.
• A PEG less than 1.0 is considered low and indicates that the stock is undervalued (good).
• Anything above 2.0 is frequently considered aggressive (bad).

3. P/S Price/Sales Ratio:

• The price-to-sales ratio shows how much investors are willing to pay per dollar of sales for a stock.
• It’s calculated by dividing the stock price by the underlying company’s sales per share.
• A low ratio  implies that a stock is undervalued (good), while a high ratio indicates that the stock is overvalued (bad).
• When a company experiences a period of early growth, investors place an unrealistic valuation.
• When the value of the company drops below their expectations, investors panic and sell the stock.

4. P/B Price/Book Ratio:

• Comparing its market price to its book value indicates if the stock is underpriced or overpriced.
• Ratio less than one = trading at less than its book value, or stock is undervalued and a good buy.
• Ratio greater than one can be interpreted as being overvalued or relatively expensive.
• It’s better to compare P/B ratios within industries.

5. P/CF Price/Cash Flow:

• The cash flow to sales ratio is cash generated by the regular operating activities of a business.
• Divide the share price by the operating cash flow per share
• A low ratio indicates that a company is generating ample cash flow that is not yet properly considered in the current share price (good).
• A high ratio indicates that a company is trading at an overvalued range and is not generating enough cash flow to support the multiple (bad).
• It’s more insightful when it is compared with companies within the same industry.

6. D/E Debt To Equity Ratio:

• The debt-to-capital ratio is a measurement of a company’s financial leverage (loans).
• This ratio is used to evaluate a firm’s financial structure and how it is financing operations.
• It focuses on the relationship of debt liabilities as a component of a company’s total capital base.
• Capital includes the company’s debt and shareholders’ equity.
• A low debt to equity ratio implies a more financially stable business (good).
• A high debt-to-capital ratio indicates that it uses debts to finance operations and assets that can lead to danger of selloffs and higher default risk (very bad).

Sample list of overvalued stocks:

• Enphase Energy (ENPH)
• IDEXX Laboratories (IDXX)
• ServiceNow (NOW)
• Square (SQ)
• Tesla (TSLA)
• Amazon (AMZN).

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Victor Santos Sy, MBA. CPA (Retired)

Victor Santos Sy graduated Cum Laude from UE with a BBA and from Indiana State University with an MBA. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation.

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He retired after 50 years of defending taxpayers audited by the IRS, EDD, BOE and other governmental agencies.  He published a book on “How to Avoid or Survive IRS Audits” that’s available at Amazon. Readers may email tax questions to [email protected].