Many investors wonder how to figure out whether a stock is overvalued and should not be at the top of their buying list. The price-to-earnings (P/E) ratio, also known as an "earnings multiple," gives you a quick way to figure out a stock's value, but it doesn't mean much until you know how to read the result.
Signals of Overvalue
A stock is thought to be overvalued when its current price doesn't line up with its P/E ratio or earnings forecast. If a stock's price is 50 times earnings, for instance, it's likely to be overvalued compared to one that's trading for 10 times earnings.
Some people think the stock market is efficient. They'll say that value is factored into stock prices almost right away. But others, like fundamental analysts, think you'll always find wrongly valued stocks in the market because people sometimes depend on their feelings instead of their logic when they invest.
PEG and Dividend-Adjusted PEG Ratio
Both the price/earnings-to-growth (PEG) and dividend-adjusted PEG ratios can be useful when you're trying to decide the true value of a stock. Just keep an eye out for the rare instance when that's not the case.
First, take a look at the projected after-tax growth in earnings per share (EPS), fully diluted, over the coming few years. Next, look at the P/E ratio on the stock. Using these two numbers, you can find the PEG ratio. Here's how:
P/E ratio ÷ company's earnings growth rate
If the stock pays a dividend, you might want to use the dividend-adjusted PEG ratio formula:
P/E ratio ÷ (earnings growth + dividend yield)
The upper threshold that most people want to watch for is a ratio of two. In this case, the lower the number, the better. Anything at one or below could be a good deal.
Again, this isn't set in stone. For instance, if you have a lot of knowledge of a certain industry, you might spot a turning point in a firm that's closely tied to economic cycles. Then you might decide that the earnings might turn out to be stronger than they are being forecast.
There may be cases when a stock could be valued other than the way it appears at first glance, but for most people this rule will help protect against losses.
Relative Dividend Yield Percentage
You might find that a stock's dividend yield is, at present, in the lowest 20% of its total range over time. There are many reasons why that might be the case. It could be that the sector it's in is going through a time of profound change, or perhaps the firm itself has been changing its methods. But a company's core functions are mostly going to be stable over time, with a fairly likely range of outcomes. The stock market might be fraught, but the actual work of most businesses, during most time frames, is much more stable. (At least when they're viewed over full economic cycles, that is.)
Take a company such as Chevron, for instance. Looking back, any time Chevron's dividend yield has been below 2%, investors should have been wary, as the firm was overvalued. Likewise, any time it got close to the 3.5%–4% range, it should have gotten a second look, as it was undervalued.
The dividend yield served as a signal. It was a way for people to look at the price as it relates to the profits. It was also a way to strip away the complex data that can arise when dealing with Generally Accepted Accounting Principles (GAAP) standards.
To track and check a dividend yield over time, first map out the dividend yields over several points in time. Then, divide the chart into five equal parts. Any time the yield falls below the bottom fifth, be wary.
As with the other methods, this one is not perfect. But when you follow it as part of a well-run portfolio of quality, blue-chip stocks, you can get some good results. It also can force you to behave in a routine way, making regular buys into the market whether it's up or down.
Certain types of firms, such as home builders, car makers, and steel mills, have unique traits. These firms tend to see sharp drops in profit during times of decline. They also see large spikes in profit during times of growth. When the latter happens, you may be enticed by what appear to be quickly growing earnings, low P/E ratios, and, in some cases, large payouts.
But when this happens, it's known as a "value trap," and it can be risky. These traps appear at the tail end of economic expansion cycles, and they can ensnare new investors. If you're wise, you'll see that the P/E ratios of these firms are much, much higher than they appear.
Compare With Treasury Bond Yield
A stock's earnings yield, as compared to the Treasury bond yield, can provide one more clue in testing its value. Whenever the Treasury bond yield exceeds the earnings yield by 3:1, be careful. You can find this out using the following formula:
(2 ÷ 30-year Treasury bond yield ) ÷ Fully-diluted EPS
For example, if a company earns $1 per share in diluted EPS, and 30-year Treasury bond yields are 5%, the test would show that the stock is valued too highly if you paid $40 or more per share: [(2/.05)/1 =40] . That sends up a red flag that you're being too optimistic about your returns.
Treasury bond yields have only exceeded earnings yields by 3:1 a few times every couple of decades, but you should be aware that it is seldom a good thing. If it happens to enough stocks, the stock market as a whole will likely be very high in relation to Gross National Product (GNP). When that happens, it is a major warning sign that stock values are cut off from reality.
Don't forget to adjust for economic cycles as well. For instance, during the 2001 recession, a lot of great businesses had large, one-time write-offs that resulted in very low earnings and very high P/E ratios. The firms grew more stable in the years after because no long-term damage had been done to their core functions in most cases.
Not buying a stock that is overvalued is not the same as holding on to a stock that has gotten ahead of itself in the short term. There are plenty of reasons you might not sell a stock that is overvalued. Many of these involve trade-off choices about opportunity cost and tax rules.
The Bottom Line
It's one thing to hold something that might have run out 25% higher than your best guess on value. It's something else if you're holding stocks with values so inflated that they make no sense at all in a sane market. One danger is a desire to trade often. When you own stock in a great business, which likely boasts a high return on equity, high return on assets, and high return on employed capital, the stock's value is likely to grow over time.
It's often a mistake to part with a stock just because it might have gotten a bit pricey from time to time. Look at the returns of Coca-Cola and PepsiCo. Even though their stock prices have been valued too highly at times, you would have been filled with regret later after selling off your stake.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.