Investing in the stock market requires most active investors to distinguish

between undervalued and overvalued stocks in order to achieve great and

consistent returns. This article is going to briefly introduce you to how you can
determine if a stock is either undervalued, fairly valued, or overvalued. 

What’s an Undervalued/Overvalued Stock?

First of all, what does it really mean if a stock is undervalued or overvalued?

 
Have you ever heard of the famous saying “buy low and sell high”? This rule
does make sense but it is more difficult to accomplish than it may seem.

If everyone was able to buy stocks when prices were “low” and sell as soon as
they turn “high”, there would be a lot more successful investors, and investing
would be a child’s play.

 
Buying low and selling high essentially means buying undervalued stocks and
selling them when they become overvalued. But how do you know what’s low
and high?

 
For instance, if a stock was priced at $5 per share one month ago and is now
trading at $20, would it now be the time to sell the stock because its price is
now “too high”?

Probably not. You can’t just blindly say that any stock is overvalued as soon as
it jumps from $5 to $20 without knowing any further details about the stock
itself, right? $20 is certainly much higher than $5 but the stock could still be
considered undervalued.

So in order to determine if a stock is undervalued or overvalued, we need to

analyze the fundamental value  of the underlying business and decide whether
the current stock price justifies those fundamentals or not. 

 
The Difference Between Price and Value
“Price is what you pay, Value is what you get. “
Warren Buffett
This one may seem obvious but it’s one of the most important things to
understand about investing in general.

There is a distinct difference between price and value and not every stock price
will always reflect the true value of each stock.

For example, as of December 2020, Facebook (FB) is currently trading at

around $270 per share. Let’s suppose that the stock price would suddenly jump
to the sky the next day. Instead of $270, one share of Facebook would now be
trading at $2000.

Let’s assume that absolutely nothing has changed within the company or
regarding any factors outside the business. Would you consider buying the
stock? Or would a price of $2000 per share just seem too ridiculous to you for
what the company currently offers?

If you wouldn’t be willing to pay $2000 for the stock, how much would you pay if
you had the choice? Would it be $250, $150, or $50 for one share?

Regardless of the price that you choose for yourself, that price point would be
what investors call “fair value”. The fair value of a stock is essentially the price
that you personally think the stock is worth right now.
How to Tell Whether a Stock Is Undervalued or
Overvalued
One of the options for you to determine whether a stock is undervalued or
overvalued is to use valuation metrics and compare them to other similar
companies, historical values, or industry averages. 

The most well-known valuation metric is the P/E ratio. If for example, a
company is trading at a lower P/E than its competitors, this may indicate
that the stock is undervalued, whereas a higher P/E would reveal that the
stock may be overvalued. 

That being said, using the P/E on its own to value stock is definitely not the only
method and can oftentimes be very misleading and insufficient. Before we
cover the P/E ratio and other metrics in more detail, let’s quickly go through
each situation that you can possibly encounter when assessing the value of a
stock:

 1. The current stock price is higher than its fair value, meaning that the
stock is overvalued. You would currently pay a premium for what it’s truly
worth.
 2. The current stock price is equal to its fair value. The stock price is
where it’s supposed to be and you would be able to buy the stock for its
intrinsic value (fair value).
 3. The current stock price is lower than its fair value, meaning that the
stock is undervalued. You can buy the stock for less than what it’s truly
worth right now.

How to Assess the Value of a Stock

There are many ways to assess the value of a stock. The whole topic of
valuation is something that entire books have been written about.

As already mentioned, of the easiest and less complicated valuation methods

investors can use is applying valuation ratios and metrics in order to determine
whether a stock is either undervalued, fairly valued, or overvalued. 

The P/E ratio

The most commonly used metric when it comes to investing is the price-to-
earnings ratio. The earnings multiple describes the current price of a stock in
relation to the earnings of the stock in a quick and easily understandable way.
 

You can calculate the P/E ratio by dividing the current stock price with the
earnings-per-share (EPS) of the business:

Whereas earnings per share is the amount of a company’s net profit divided by
the number of outstanding shares:

The higher the P/E ratio, the more overvalued a stock may be. Conversely, a
lower P/E might indicate a more undervalued stock.

One way to look at the P/E is by imagining how much you would have to pay for
$1 in earnings out of the business.

For instance, if stock A currently trades at a P/E of 15, you would have to pay
$15 in order to get $1 as earnings out of the business. Stock B on the other
hand, has an earnings multiple of 40, meaning that you would currently have to
pay $40 for every $1 in earnings.

As a result, you would have to pay to a higher degree for stock B’s earnings
compared to stock A.

In this case, stock B would theoretically appear more overvalued than stock A.
However, not every stock that has a higher P/E than others is necessarily more
overvalued.

 
»Learn more about the P/E ratio and its flaws

Different companies across multiple industry sectors will have different

standards of P/Es. For example, a tech stock such as Netflix (NFLX) will
generally have a much higher P/E ratio than a financial company like JPMorgan
(JPM).

This is mainly because investors are willing to pay higher premiums for
companies that offer higher growth potential. A business like Netflix is simply
expected to grow more rapidly than a financial bank like JPMorgan, meaning
that investors will overpay, despite the current prospects of the company.

Comparing P/Es of tech stocks with financial stocks is like comparing apples to
oranges. It doesn’t really make sense. You should mainly use the P/E ratio of a
stock in comparison with similar companies within the same industry, or with its
own historical standards.

As an example, if a company is trading at a P/E of 20, but the historical average

of P/E’s for the business is 30, it can be a good sign that the stock is currently
undervalued. 

The PEG ratio

A major flaw of the P/E ratio is the fact that it doesn’t tell anything about the
future since it only represents the current price in relation to the past earnings.

For instance, if a stock has a P/E of 5 but is not growing but instead shrinking,
that stock isn’t likely to be a good investment, despite its low P/E. On the flip
side, if a stock has a P/E of 50 but is growing tremendously, that company still
might be a great and fairly valued investment.

 
Somehow, the growth aspect needs to be taken into account, and this is where
the PEG ratio comes into place.

The PEG ratio is like an enhanced version of the P/E ratio but eliminates one
major flaw by additionally considering the growth factor of the company’s
earnings.

You can calculate the PEG ratio by dividing the P/E ratio by the EPS growth
estimate of the company.

You can either anticipate the earnings growth for yourself or use the estimates
of analysts. Most analysts usually calculate earnings growth based on the
percentage change of EPS over the previous 12 month period.

Note that the PEG ratio for each stock can vary, depending on the growth rate
that is used in the calculation. This makes the PEG ratio a little harder to use
than the P/E ratio.

Calculation Example

Company XYZ is a mature company with a P/E of 18 times earnings. A large

number of analysts expect the stock’s earnings to grow 12% annually over the
next 3 years.

Consequently, you would have to divide the P/E of 18 by the growth rate of 14%
to arrive at a PEG ratio of 1.29.
 

Interpreting the PEG Ratio

In theory, a PEG ratio of below 1 suggests that the company is undervalued,
while a PEG ratio of 1 should reflect a fairly valued stock, A PEG ratio above 1
would indicate that the stock is rather overvalued.

The general rule is that the lower the PEG ratio the more undervalued a stock
might be, whereas a PEG ratio of above 2 should raise skepticism, as that
indicates a very overvalued stock.

»Learn more about understanding and using the PEG ratio.

One advantage of using the PEG ratio is that it lets you compare stocks with
different P/E standards.

For example, if you compare stock A with a P/E of 14, and a growth rate of 8%
with stock B that has a P/E of 40 but is growing 35%. By using the PEG ratio,
you would come up with a PEG ratio of 1.75 for stock A and 1.14 for stock B.

From this perspective, stock B would be more undervalued than stock A,

despite the fact that stock B has a much higher earnings multiple. 

Conclusion
In order to determine whether a stock is undervalued or overvalued, you need
to analyze the stock’s fundamental characteristics relative to the current market
price. 

One approach of assessing a stock’s value is using different metrics ratios and
comparing them between different companies and historical records. 
Both the P/E ratio and the PEG ratio have their own benefits and flaws. While
the P/E ratio can be used to quickly gauge the value of a stock, it can also be
misleading in many cases. The PEG ratio eliminates a major flaw of the P/E
ratio and allows comparisons between all types of companies across different
industries but depends on accurate growth estimates.

All that being said, more advanced investors and professionals don’t
necessarily just compare valuation metrics in order to come up with the intrinsic
value of a company. What is most often being applied in valuation are financial
models such as the discounted cash flow, which does take more knowledge
and practice to be made use of. 

Nevertheless, valuation metrics such as the P/E and PEG ratio can still come in
very handy when trying to quickly gauge the value of a stock.