How To Tell When a Stock Is Overvalued

Some Warning Signs a Stock Might Be Trading In Dangerous Territory

How to Tell When a Stock Is Overvalued
Learning how to tell when a stock is overvalued is an important skill for any investor as it allows you to better defend yourself, even if imperfectly, from bubbles and manias. Here are a few warning signs that should cause you to take a closer look at a potential investment. chipstudio / Getty Images

Over the years, many investors have asked me how to tell when a stock is overvalued. It's an important question, and one that I want to take some time to explore in-depth, but before we get into that, it's necessary for me to lay some philosophical groundwork so you understand the framework through which I view capital allocation, investment portfolio construction, and valuation risk. That way, we can minimize misunderstandings and you can better evaluate where I am coming from when discussing this topic; the reasons I believe what I believe.

A Capital Allocation Philosophy

Let me start with the technical explanation: First and foremost, I am a value investor. This means that I approach the world very differently than a majority of investors and people working on Wall Street.  I believe that investing is the process of buying profits.  My job as an investor is to build a collection of cash generating assets that produce ever-increasing sums of surplus owner earnings (a modified form of free cash flow) so that my annual passive income increases over time, preferably at a rate considerably higher than the rate of inflation.  Furthermore, I focus on risk-adjusted rates of return. That is, I spend a lot of time thinking about the safety of the risk/reward relationship between a given asset and its valuation and am primarily concerned with avoiding what is known as permanent capital impairment. By way of illustration, all else equal, I would gladly take a steady 10% rate of return on a high quality blue chip stock that had an extremely low probability of bankruptcy, which I could someday gift to my future children and grandchildren through the stepped-up basis loophole (at least on the portion below the estate tax exemption), than I would a 20% rate of return on shares of common stock in a regional airline.

 Though the latter can be a highly profitable trade, that's not what I do.  It takes an extraordinary margin of safety for me to be tempted into such positions and, even then, they are a relatively small percentage of capital because I am aware of the fact that even if all else is perfect, a single non-related event, such as a September 11th, can result in the near instantaneous bankruptcy of the holding.

 I worked very hard to build wealth early in life and have no interest in seeing it wiped out so that I have a bit more than what I already do.

Now, let me provide the laymen's explanation: My job is to sit at my desk all day and think of intelligent things to do.  By using my two buckets - time and money - I look around at the work and try to think of ways I can invest those resources so that they produce another annuity stream for me and my family to collect; another river of money coming in 24 hours a day, 7 days a week, 365 days a year, arriving whether we are awake or asleep, in good times and in bad times, no matter the political, economic, or cultural climate.  I then take those streams and deploy them to new streams. Wash. Rinse. Repeat. It is the approach that is responsible for my success in life and allowed me to enjoy financial independence; gave me the freedom to focus on what I wanted to do, when I wanted to do it, without ever having to answer to anyone else, even as a college student when my husband and I were earning six-figures from side projects despite being full-time students.

This means I am always looking around for annuity streams I can create, acquire, perfect, or capture.

 I don't particularly care if a new dollar of free cash flow comes from real estate or stocks, bonds or copyrights, patents or trademarks, consulting or arbitrage.  By combining an emphasis on reasonable costs, tax efficiency (through the use of things like highly passive, long-term holding periods and asset placement strategies), loss prevention (as opposed to fluctuations in market quotation, which don't bother me at all provided the underlying holding is performing satisfactorily), and, to some degree, personal, ethical or moral considerations, I am content to make decisions that I believe will, on average, result in a meaningful, and material, increase in the net present value of my future earnings.  This allows me, in a lot of ways, to be almost completely detached from the hectic world of finance.

 I'm so conservative that I even have my family hold their securities in cash-only accounts, refusing to open margin accounts due to the rehypothecation risk.

In other words, stocks, bonds, mutual funds, real estate, private businesses, intellectual property ... they are all just means to an end.  The goal, the objective, is increasing the real purchasing power, the after-tax, after-inflation cash flow, that shows up in our accounts so that it is expanding decade after decade.  The rest is largely noise.  I'm not besotted with any particular asset class.  They are merely tools to give me what I want.

Why Overvaluation Presents Such a Problem

When you understand that this is the lens through which I view investing, it should be evident as to why overvaluation matters.  If investing is the process of buying profits, as I maintain it is, it is an axiomatic mathematical truth that the price you pay for each dollar of earnings is the primary determinant of both the total return and compound annual growth rate you enjoy.  

That is, the price is paramount. If you pay 2x for the same net present value cash flows, your return will be 50% of what you would have earned if you had paid 1x, instead.  Price cannot be separated from the investing question as it exists in the real world.  Once you've locked in your price, the die is cast.  To borrow from an old retail saying that is sometimes used in value investing circles, "well bought is well sold".  If you acquire assets that are priced to perfection, there is inherently more risk in your portfolio because you need everything to go right to enjoy an acceptable return.  (Another way to think of it came from Benjamin Graham, the father of value investing.  Graham was a big proponent that investors ask themselves - and I'm paraphrasing here - "at what price and on what terms?" any time they lay out money.  Both are important.  Neither should be ignored.)

All of that said, let's get to the heart of the matter: How can you tell if a stock is overvalued?  Here is a handful of useful signals that may indicate a closer look is warranted.  Of course, you're not going to be able to escape the need to dive into the annual report, 10-K filing, income statement, balance sheet, and other disclosures but they make for a good first-pass test using easily accessible information.  Additionally, an overvalued stock can always become even more overvalued.  Look at the 1990s dot-com bubble as a perfect illustration.  If you pass on an investment opportunity because it is a dumb risk and find yourself miserable because it's gone up another 100%, 200%, or (in the case of the dot-com bubble), 1,000%, you are not suited to long-term, disciplined investing.  You're at an enormous disadvantage and may even want to consider avoiding stocks altogether.  On a related note, this is a reason to avoid shorting stock.  Sometimes, companies that are destined for bankruptcy end up behaving in a way that, in the short-term, can cause you to go bankrupt yourself or, at the very least, suffer a personally catastrophic financial loss like the one suffered by Joe Campbell when he lost $144,405.31 in the blink of an eye.

A stock might be overvalued if:

1. The PEG or Dividend Adjusted PEG Ratio Exceed 2

These are two of those quick-and-dirty, back-of-the-envelope calculations that can be useful in most situations, but will almost always have a rare exception that pops up from time to time.  First, look at the projected after-tax growth in profits per share, fully diluted, over the coming few years. Next, look at the price-to-earnings ratio on the stock. Using these two figures, you can calculate something known as the PEG ratio.  If the stock pays a dividend, you might want to use the dividend-adjusted PEG ratio.

The absolute upper threshold that most people should consider is a ratio of 2. In this case, the lower the number the better, with anything at 1 or below considered a good deal.  Again, exceptions might exist - a successful investor with a lot of experience might spot a turnaround in a cyclical business and decide the earnings projections are too conservative so the situation is much rosier than appears at first glance - but for the new investor, this general rule could protect against a lot of unnecessary losses.

2. The Dividend Yield Is in the Lowest 20% of Its Long-Term Historical Range

Unless a business or sector or industry is going through a period of profound change either in its business model or the fundamental economic forces at work, the core operational engine of the enterprise is going to exhibit some degree of stability over time in terms of behaving within a fairly reasonable range of outcomes under certain conditions.  That is, the stock market might be volatile but the actual operating experience of most businesses, during most periods, is a lot more stable, at least as measured over entire economic cycles than the value of the stock is going to be.

This can be used to the investor's advantage. Take a company such as Chevron. Looking back throughout history, anytime Chevron's dividend yield has been below 2.00%, investors should have been cautious as the firm was overvalued. Likewise, any time it approached the 3.50% to 4.00% range, it warranted another look at it was undervalued.  The dividend yield, in other words, served as a signal.  It was a way for less experienced investors to approximate the price relative to the business profits, stripping away a lot of the obfuscation that can arise when dealing with GAAP standards.

One way you can do this is to map out the historical dividend yields of a company over the decades, and then divide the chart into 5 equal distributions. Any time the dividend yield falls below the bottom quintile, be wary.

As with the other methods, this one is not perfect. Successful companies suddenly run into trouble and fail; bad businesses turn themselves around and skyrocket. On the average, though, when followed by a conservative investor as part of a well-run portfolio of high quality, blue chip, dividend paying stocks, this approach has generated some very good results, through thick and thin, boom and bust, war and peace.  In fact, I would go so far as to say it is the single best formulaic approach in terms of real-world outcomes over long periods of time I've ever come across.  The secret is that it forces investors to behave in a mechanical way akin to the way dollar cost averaging into index funds does. Historically, it has also led to a lot lower turnover.  Greater passivity means better tax efficiency and lower cost due in no small part to the benefit of leveraging deferred taxes.

3. It Is In a Cyclical Industry and Profits Are at All-Time Highs

There are certain types of companies, such as homebuilders, automobile manufacturers, and steel mills, that have a unique characteristics. These businesses experience sharp drops in profits during periods of economic decline, and large spikes in profits during periods of economic expansion. When the latter happens, some investors are enticed by what appear to be fast growing earnings, low p/e ratios, and, in some cases, fat dividends.  

These situations are known as value traps. They are real. They are dangerous. They appear at the tail end of economic expansion cycles and generation after generation, ensnare inexperienced investors. The wise, experienced capital allocators know that the price-to-earnings ratios of these firms are much, much higher than they appear.

4. The Earnings Yield Is Less than 1/2 the Yield on the 30-Year Treasury Bond

This is one of my favorite tests for an overvalued stock. Basically, when followed in a broadly diversified portfolio, it might have caused you to miss a couple of great opportunities but, on the balance, it has resulted in some fantastic results as it is almost a surefire way to avoid paying too much for an ownership stake. Someone who used this test would have sailed through the 1999-2000 bubble in stocks as they would have sidestepped great companies like Wal-Mart or Coca-Cola trading for an absurd 50x earnings!

The math is simple:

30 Year Treasury Bond Yield ÷ 2
---------(divided by)---------
Fully Diluted Earnings Per Share

For example, if a company earns $1.00 per share in diluted EPS, and 30-Year Treasury Bond yields are 5.00%, the test would fail if you paid $40.00 or more per share. That should send up a big red flag that you might be gambling, not investing, or that your return assumptions are extraordinarily optimistic.  In rare cases, that might be justified, but it is something that is definitely out of the norm. 

Whenever the Treasury bond yield exceeds the earnings yield by 3-to-1, run for the hills. It has only happened a few times every couple of decades but it is almost never a good thing. If it happens to enough stocks, the stock market as a whole will likely be extremely high relative to Gross National Product, or GNP, which is a major warning sign that valuations have become detached from the underlying economic reality.  Of course, you must adjust for economic cycles; e.g., during the 2001 post-September 11th recession, you had a lot of otherwise wonderful businesses with huge one-time write-offs that resulted in severely depressed earnings and massively high p/e ratios.  The enterprises righted themselves in the years that followed because no permanent damage had been done to their core operations in most cases.  

Back in 2010, I wrote a piece on my personal blog that dealt with this particular valuation approach.  It was called, simply enough, "You Have to Focus on Valuation Metrics in the Stock Market!".  People don't, though.  They think of stocks not as the cash-generating assets they are (even if a stock pays no dividends, as long as the ownership stake you hold is generating look-through earnings, that value is going to find its way back to you, most likely in the form of a higher stock price over time resulting in capital gains) but as magical lottery tickets, the behavior of which is as mysterious as the mutterings of the Oracle of Delphi.  To cover ground we've already walked together in this article, it's all nonsense.  It's just cash.  You are after cash.  You are buying a stream of present and future dollar bills.  That's it.  That is the bottom line.  You want the safest, highest returning, risk-adjusted collection of cash generating assets you can put together with your time and money.  All of this other stuff is a distraction.  

What Should an Investor Do When He or She Owns an Overvalued Stock?

Having said all of this, it's important to understand the distinction between refusing to buy a stock that is overvalued and refusing to sell a stock that you happen to hold that has temporarily gotten ahead of itself.  There are plenty of reasons an intelligent investor may not sell an overvalued stock that is in his or her portfolio, many of which involve trade-off decisions about opportunity cost and tax regulations.  That said, it's one thing to hold something that might have run out 25% ahead of your conservatively estimated intrinsic value figure and another entirely if you're sitting atop of complete insanity on par with what investors have at certain times in the past. 

A major danger I see for new investors is a tendency to trade. When you own a great business, which likely boasts a high return on equity, high return on assets, and/or high return on capital employed for the reasons you learned about in the DuPont model ROE breakdown, intrinsic value is likely to grow over time.  It's often a horrible mistake to part with the business ownership you hold because it might have gotten a bit pricey from time to time.  Take a look at the returns of two businesses, Coca-Cola and PepsiCo, over my lifetime.  Even when the stock price got ahead of itself, you would have been filled with regret had you given up your stake, forgoing dollars for pennies.