How do investors judge if a stock is overpriced?

We all like to talk about undervalued stocks but rarely do we venture to talk about a stock that is overpriced or overvalued. That is because most investors have a natural tendency to buy stocks rather than to sell stocks. Valuation metrics are fine but there are companies and sectors in India that are appreciating for many years without any let-up in the P/E ratio.

Take FMCG as a classic example in India. So what exactly are overvalued or undervalued stocks? How to determine if a stock is overpriced and how to find overvalued stocks in the stock market? Stock valuation is as much an art as it is a science. However, there are 5 key factors you can use to judge if the stock is underpriced or it is overpriced.

P/E ratio may be misleading at times, but the PEG gives a clearer picture

PEG is the P/E Ratio adjusted for growth. For example, P/E ratio of 25 with 20% growth may be acceptable but P/E ratio of 15% with 5% growth is not acceptable. That is where PEG creates a standardised matrix.

PEG Ratio = PE Ratio / company’s earnings growth rate:

Ideally, you must look at the prospective P/E ratio based on estimated earnings and the prospective growth rate. At the end of the day, the stock price of the company factors the future performance and not the past performance. Hence a futuristic approach to PEG can work better from an analytical standpoint.You can also use a slightly modified version of the formula PEG which is called the dividend adjusted PEG.

Dividend-adjusted PEG ratio = PE ratio / (earnings growth + dividend yield):

In this case, the lower the number the better, with anything at 1 or below considered a good deal. The level of 2 is considered the upper limit of overpricing. Beyond that the stock is truly overpriced and calls for action.

Examine the likelihood of a cyclical industry

Certain sectors such as homebuilders, automobile manufacturers, and steel mills have unique characteristics. These businesses tend to experience sharp drops in profit during periods of economic decline, and large spikes in profit 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, large dividends. This is popularly called a value trap.

Compare the earnings yield with the bond yield

There is a very smart logic to this argument. The earnings yield is the inverse of the P/E ratio. So a company with a P/E ratio of 20 has an earnings yield of 20%. It is measured as under:

Earnings Yield = Earnings per share (EPS) / Market price of the stock:

Earnings yield in isolation does not mean anything. It has to be seen in conjunction with the yield on government securities or safe bonds. For example, if the earnings yield is 6% and the bond yields are 4% then the situation is normal as you are getting more on equities than on bonds due to the higher risk entailed. But if the earnings yield is 3.5% and bonds are yielding 6.5% then it is a clear case of overvaluation of equities. This is the time to make your move out of equities.

Too much dependence on one product line

This is a slightly more qualitative factor for company valuation. But always remember the story of the Forbes cover story of Nokia in 2007 calling it an invincible company. The company was almost entirely bankrupt within 4 years due to the onslaught of smartphones. Nokia’s profits were unsustainably high but the stock market had priced in that the current level of profits is sustainable. When economic conditions change or a key product falls out of favour there tends to be downside to both the company’s profits and valuation, leading to a significant share price fall.

Beware of management sweet talk and accounting jugglery

This is again a qualitative factor and relies more on judgement than on hard facts. But the signals are there for all to pick up. If you look at cases like Enron, Lehman Brothers, Satyam or Kingfisher Airlines it was an eclectic mix of management bravado and accounting jugglery at its worst. This is where a business’s management, sell-side analysts or others stop focusing on traditional metrics, such as earnings, and come up with their own.

As John Templeton rightly said, “The most dangerous argument in financial markets is that this time it is different”. Be cautious of valuations when the company starts talking about metrics like EV / EBITDA etc. In some cases, the accounting issues may be hiding that a company is in financial difficulty or even insolvent. Whenever you find the managements and accountants getting too aggressive, it is time to be cautious about valuations.

(The writer is MD and CEO of Broking & Distribution, Motilal Oswal Financial Services Ltd)