How to know if a Stock is Overvalued or Undervalued?

Nowadays, everyone is looking for ways to determine whether a stock is undervalued or overvalued for smart investing. Having said that, one should also not forget that what may be overvalued for you might be undervalued for another person. For example, you are selling your stock because you think it’s overvalued, and you’re getting a better return. On the other hand, the person who’s buying your stocks thinks it to be undervalued and still has expectations that it might provide a better return in the future. Therefore, this concept is not the same for everyone.

However, there are ways through which you can still determine if the stock is undervalued or overvalued. Mentioned below are some of the ways which will help you get an idea about the value of the stock.

1. P/E Ratio

Price earning ratio is the best metric that can be used for determining the value of the entire stock value. This ratio shows the amount a buyer is willing to spend per rupee of earnings. One can get this ratio by measuring the current price of the share relative to the earning per share. For example, currently, an enterprise is trading at P/E of 20. Therefore, the interpretation says that the investor would be willing to spend Rs.20 for current earnings of Rs.1.

However, one should always look P/E in accordance with the margin, brand wealth, and growth. This is because the stock of 10 P/E should not be compared with the stock of 20 P/E. For example, Maruti has been able to achieve a higher P/E because of steady growth month after month. However, Britannia and Hindustan Unilever have a higher P/E ratio because of their brand value.

2. P/B Ratio

The P/B ratio is one of the most convenient ways to find whether the stock is overvalued or undervalued. Apart from that, a company’s valuation is also evaluated using this ratio. One can get the price book value by measuring the market value of the share price of a company over the value mentioned on the balance sheet.

However, one needs to get that this ratio isn’t some magical formula. The P/B ratio is tilted towards industry-specific and is selective. Generally, this method is used in financial businesses, transportation or energy firms, and capital-intensive businesses. Therefore, a bank having a lower P/B ratio is termed as undervalued.

3. EV/EBITDA

Whenever a company is acquired or merged, the best way to assess stock undervaluation is by using a valuation measure called EBITDA. This valuation measure mostly works for internet companies, telecom companies, and power companies. This is because these sectors usually take a few years to make profits. And when it comes to this, the P/E ratio is not much of use.

Here, you get the enterprise multiple by measuring enterprise value over EBIDTA. Let’s break it down to simpler terms. A company’s market value, minus the external debt, is considered as the enterprise value (EV). On the other hand, EBIDTA includes earnings before taxes, amortization, interest, and depreciation. If the Enterprise multiple (EM) value is less, the stock becomes undervalued.

4. Dividend Yield

Yet another effective way to determine whether the stock is overpriced or under-priced can be done with the help of dividend yield. When it comes to M&A situations, it’s quite effective.

Usually, when the stock price is less, the dividend yield is high. However, one can get the dividend yield by measuring the dividend per share over the price per share.

Let’s take an example to understand the concept clearly. If a stock is priced at Rs.100 and it pays dividends at Rs.5, then 5% is the dividend yield. So, the higher the dividend, the less valued the stock, and vice-versa. Since the market always thrives for consistent growth, the higher dividend yield isn’t seen as a positive sign.

5. Safety Margin

To estimate a company’s valuation, this is a very new strategy. Warren’s Buffettolog, which has become very popular recently, has introduced this way of valuation. So, basically, the safety margin is a gap between the market’s actual price and the stock’s intrinsic value. Therefore, the higher the safety margin, the more overvalued will be the stock, and vice-versa.

CONCLUSION

All of the measures mentioned above can effectively determine whether the stock is undervalued or overvalued. People think that it’s better not to buy a stock when the entire market is overvalued. Unfortunately, they’re not correct. While the entire market is overvalued, there are other individual stocks that might be undervalued. Undoubtedly, it’s tough to find such stocks, but it’s not impossible. Moreover, one can never know when the market situation might start tumbling. Hence, be ready with cash to be able to take advantage when the prices drop or when you find an undervalued stock.