How to Tell if a Stock is Overpriced?

Answer 1

Have you ever been listening to analysis on an individual stock and heard the analyst say they believed the share price was too high? How do analysts tell if a company’s stock is overpriced? Mostly they use complicated metrics that are beyond the scope of this blog, but one simple tool that you can use, and one that’s still relevant to those stock analysts is the P/E ratio.

P/E ratio, or Price to Earnings ratio, compares the stock price to the earnings per share of the company. The earnings per share is a measure of how much the company’s earnings are per share of stock outstanding. In essence then, if the P/E ratio was 15, it’d mean that the company’s stock was trading at 15 times earnings. In this example the EPS (earnings per share) would only be 1/15 of the share price.

One reason that P/E ratio is a good measure of whether the stock is overpriced is that if the ratio is high, you’re paying a whole lot for mediocre performance. Or the company may have good performance but be overbought due to market hysteria or some sort of bubble.

Industries and sectors of the market all tend to be grouped within a narrow range of typical P/E results. If you compare an energy company to another similar energy company, you’ll most likely find that their P/E ratios are similar. So one measure of whether a particular stock is overpriced would be to compare its P/E ratio to that of other similar companies.

This tool should be added to your toolbox; but it shouldn’t be used in a vacuum. Remember to do thorough research on any company before deciding to purchase shares of its stock. The P/E ratio can help you avoid overpaying for an investment, but it cannot tell the whole story of what’s going on within the company, the economy, that individual sector, or the market as a whole.

While the P/E can help you identify stocks that are overpriced, it is also useful to help you spot a potential bargain. But again, sometimes the P/E may be low because a strong company is overlooked by the market – other times there will be other reasons why that metric dips below the average for its sector. Do your research, but make sure that P/E is included in the screens that you use when evaluating individual stocks.