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How Do You Identify Overvalued Stocks?

By Louis H-P on May 12, 2020

Reading Time: 4 minutes

Among the biases that investors display is holding on to long to overvalued stocks. It is difficult for investors to get round the idea of selling out early, and missing out on an extra 10%. Often this is best, because holding on too long means selling too late, often losing out on much more than 10%! Timing when to sell stocks is never easy, but you do not lose money by banking a profit.

Key Takeaways

Identifying overvalued stocks

Risks attached to them

Limiting your downside risk


Why do stocks become overvalued?

Stocks can become overvalued for many reasons but two of the most common are the following. Firstly because it is a fantastic company, which regularly increases its profits and dividends year on year. Think of a Diageo, Its shares are expensive because of the premium that investors attach to its stable returns.

A quality company can unfairly appear overvalued. 

Secondly because a stock has managed to sell such a brilliant story to investors, that few pay attention to the financials. Tesla springs to mind here. In both cases the shares are expensive but are supported for vastly different reasons. Over the long-run one will be given more leeway to under perform (Diageo) than the other (Tesla).

How can you be sure you are seeing overvalued stocks?

Financial metrics are the key. Price to Earnings (P/E) and Price to Book value are the traditional ratios to use. They allow comparison between companies in a same sector and against the wider market.

They are just ratios though. Ratios should be used in conjunction with other metrics, such as free cash flow. If a company is highly rated but is not generating any free cash flow, then it cannot afford it’s dividends or debt repayments. Is it worth the risk of holding on to it?

To the future and beyond

Sometimes an entire sector of the market can become overvalued as it is seen as the next big thing. In the early 2000s the technology sector was seen as the place to be for all investors.

Any reasonable investor should have noticed that virtually the entire sector, which was borrowing money and issuing equity left, right and centre without generating free cash flow, was overvalued and very risky. Cue the Dotcom crash where companies went bankrupt and investors lost a lot of money.

Today’s technology will change our lives.

Today the technology sector is once again taking centre stage. The growth of technology stocks has been simply huge. Apple is up 811% since May 2010 at the time of writing!

Although many of the big tech companies of today are on expensive valuations, they have large cash reserves, backed by solid profits and cash flows.

The Coronavirus of 2020 will also exacerbate a change to home working and the dependency on their technology. In turn protecting profits and likely increasing them.

No barriers to entry, no economic moat!

Some stocks such as Unilever and Reckitt Benckiser are seen as having stable profits due to the necessities of everyday life they sell. As a result they are accorded a premium. Some would see them as over-valued, others as bond like profits – e.g. their dividend is safer than many other companies. Critically these firms and their brands are strongly established. It is difficult for others, though not impossible, to take market share. In effect, they have barriers to entry.

Peloton is included in the list of overvalued stocks!

One stock which has the hallmark of a fad is Peloton, not to mention being over-valued. There is no equity risk premium accorded to it. Slick marketing featuring slim and beautiful people smiling is all very good, but asking clients to pay $2,245 for a bike before you get started is a bit much. If competitors produce a more realistically priced bike, or even better attach a screen to a indoor bike, Peloton will lose clients.

As an investment, its unique selling point can be easily copied – so its share price should reflect this risk. Instead it has jumped upwards (see above chart), increasing the value of its shares to heights which its financials do not, and will not likely sustain. Anyone seeking a margin of safety should look elsewhere!

Trading specific factors

Occasionally an overvalued stock can appear as a result of trading specific factors, such as momentum investing. Another example would be short covering and the Tesla share price in February 2020. Tesla stock is seen by some as the stock of the future due to its focus on environmentally friendly electric cars and the batteries it manufacturers. Others see it as a story which, although has some credibility, has got ahead of itself in valuation terms.

As a result, some fund managers were shorting the stock, I.e. betting that it would go down. Unfortunately for them, the thematic investing belief in the stock was so strong that it kept rising and they started to see huge (unrealised) losses appear…

To exit their short positions required buying back the stockpushing the shares even higher! Tesla became more valuable than many large carmakers who were making millions of cars a year versus the thousands it produced!

Overvalued stocks: plain stupid

In March 2020 as investors realised that everyone was working from home, they searched for technology companies which supported this. Cue Zoom Video Communications Inc whose NASDAQ ticker is ZM, which as the name suggests provides video calls.

Problem is, many investors who were clearly not doing their homework bought Zoom Technologies,  a Chinese company with the ticker ZOOM, which manufacturers mobile phone technology! So serious was the spike in the shares, in the process driving up its value, that the SEC had to get involved!

Conclusion

Overvalued stocks can generate a premium for sound financial reasons. Be careful, as they are just as likely to do so because of investor ignorance. The rise of social trading and copy trading means more investors are buying the same stocks as each other.

Just because the market and famous investors think that something is a good idea, does not mean it is the case. Just ask Warren Buffet who for years recommended against airlines, only to buy the major US ones and then sell them because he was mistaken.

Harder still is sitting on your emotions when the entire market is roaring ahead. Do you have any regrets for having missed out on cryptocurrency trading? Your instinct tells you to sit it out, but your emotions tell you to buy in. One way around this is to buy a small blocking position, i.e. 20% of what you would normally commit to a single position. If the shares keep going up, you reduce your opportunity loss. If the shares sell off, you have only risked a small amount of your capital!

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Louis H-P

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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Louis H-P

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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