What Does Overvalued Mean?
An overvalued asset is an investment that trades for more than its intrinsic value. For example, if a company with an intrinsic value of $7 per share trades at a market value $13 per share, it is considered overvalued.
An investment is other undervalued or overvalued compared to its intrinsic value. Because an investment’s intrinsic value is subjective, so is its “over/under” valued label.
As a refresher, the intrinsic value of an investment is the price a rational investor would pay for the investment. The concept is most commonly represented by the Net Present Value (NPV) of all future cash flows the investment will produce. For a recap on the subject, please see CFI’s valuation methods guide, as well as the financial modeling guide, and types of financial models.
Undervalued vs. Overvalued
If the value of an investment (i.e., a stock) trades exactly at its intrinsic value, then it’s considered fairly valued (within a reasonable margin). However, when an asset trades away from that value, it is then considered undervalued or overvalued.
Value vs. Growth Investing
Investors who subscribe to the concept of value investing will not purchase stocks that are above their intrinsic value. Instead, they only look for opportunities to find “cheap” stocks. The opposite of a value investor is a growth investor, which is someone who believes that the stock is, in fact, not too expensive and will deliver more growth then the market (i.e., other investors) expect.
Short vs. Long Strategies
When a stock is overvalued, it presents an opportunity to go “short” by selling its shares. When a stock is undervalued, it presents an opportunity to go “long” by buying its shares. Hedge funds and accredited investors sometimes use a combination of short and long positions to play under/overvalued stocks. To learn more about trading, check out CFI’s technical analysis guide.
Ratios for Overvalued Investments
There are many tools investors can use to discover assets (usually stocks) that are worth less than the price they have to pay for them. Here are some examples of commonly used ratios for assessing whether a stock is undervalued or not:
Price vs. Net Present Value (P/NPV)
Price-to-NPV is the most complete method for valuing an investment. To perform P/NPV analysis, a financial analyst will create a financial model in Excel to forecast the business’ revenues, expenses, capital investments, and resulting cash flow into the future to determine the Net Present Value (NPV).
Next, the financial analyst will compare the resulting value from the Discounted Cash Flow (DCF) analysis to the market value of the asset. Check out CFI’s free financial modeling guide to learn more.
More Valuation Ratios
If a financial analyst doesn’t have enough time or information to create a financial model from scratch, they may use other ratios to value the company, such as:
- Enterprise Value to Revenue
- Enterprise Value to EBITDA
- Price to Earnings
- Price to Book Value
- Price to Cash Flow
- Dividend Yield and/or Dividend Payout Ratio
When using the financial ratios above, it’s important to avoid falling into the “overvalued trap.” Since companies can regularly have fluctuations in their financial statements, the ratios may appear more unfavorable then they should be over the long term.
A company can often incur one-off expenses on their Profit and Loss (P&L) Statement or include an asset write-down on their Balance Sheet when such accounting practices don’t automatically represent the long-term expected performance of the company.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: