Investors who buy and sell individual stocks should have an investment philosophy to help guide their decision making. One approach that’s used by some of the all-time best investors, including Warren Buffett, is to focus on a company’s intrinsic value, or what a stock is worth based on the underlying business’ future results. When a stock sells for significantly less than its intrinsic value, it presents a good investment opportunity, and when it sells for more than its intrinsic value, the stock should be sold or avoided as an investment.
But how do you determine whether a stock is overvalued or undervalued? A business is worth the discounted value of all the cash it will generate for its owners over the life of the business. Determining this involves making several projections about the future of the business, the economy and interest rates.
Fortunately, there are some simple ratios and signals that can be helpful in determining whether a stock is cheap or expensive. It’s worth noting that no single metric is perfect and any use of these ratios or signs to determine business value should be considered along with a complete analysis of the company’s business and industry.
1. Valuation multiples are elevated
One of the quickest ways to get a gauge of a company’s valuation is to look at ratios that compare a stock’s price to a measure of its performance, such as earnings per share. By looking at these ratios and comparing them to other companies in the same industry as well as the overall market, you can get a sense for how the company is being valued. If the valuation multiple is above that of key competitors, it could be because the stock is overvalued.
Here are some of the most popular valuation ratios.
The price-to-earnings (P/E) ratio is one of the most widely used ratios in investment analysis. It compares a company’s stock price to its earnings per share and is a way for investors to know how much they’re getting in earnings power relative to the price they’re paying for the stock. Generally speaking, it is better to pay a low P/E ratio than a high one, but there are many exceptions to that rule.
The P/E ratio can be thought of as a way to measure the market’s view of a company’s future earnings growth and the confidence it has in the growth becoming reality. High-growth companies tend to trade at higher P/E multiples than low-growth companies, but moderate- or low-growth businesses may also trade at elevated multiples if the market has a high degree of confidence in the outlook.
In recent years, some businesses have traded at extremely high P/E multiples as record-low interest rates forced investors to pay up for growing businesses. Amazon’s stock has performed extremely well despite having an elevated P/E multiple for much of its existence. The company’s low level of reported earnings pushed the ratio up as the management team reinvested earnings to grow the business. In early 2022, some of these businesses saw their stocks decline as investors grappled with the prospects of higher interest rates.
The enterprise value (EV) to EBIT is very similar to the P/E ratio, but it uses more than just price and earnings-per-share in its calculation. EV accounts for debt that the company may use for financing and EBIT calculates earnings before interest and taxes.
EV can be calculated by adding a company’s interest-bearing debt, net of cash, to its market capitalization. Next, by using EBIT you can more easily compare the actual operating earnings of a business with other companies that may have different tax rates or debt levels.
Look at how the EV/EBIT ratio compares to other companies in the same industry. If there are differences between companies, understand why that may be. Do they face similar or different futures? If the outlooks are similar across the industry, there probably shouldn’t be a wide discrepancy in valuation multiples.
The price-to-sales (P/S) ratio is a fairly simple ratio that is calculated by dividing a company’s market capitalization by its revenue over the previous 12 months. This ratio can be useful for companies that have low or negative earnings due to one-time factors or are in their early stages and investing heavily in the business. Remember that generating sales is not the ultimate goal for an investor, but rather profits. So, beware of companies touting how attractive their stock is on a price-to-sales basis if they haven’t proven they can generate actual earnings.
The software industry is an area where the P/S ratio may be useful in valuation analysis. Software companies can be extremely profitable, but often invest capital heavily during the early stages of their business, causing them to show negative earnings, or losses. By using the P/S ratio, you can get a sense for the valuation despite the companies reporting losses.
But before purchasing shares in a company with no earnings, be sure to understand how they plan to report earnings in the future. A company that will never generate a profit typically isn’t worth much to its owners.
2. Company insiders are selling
Another way to tell if a company might be overvalued is to pay attention to what company insiders are doing with their shares. Employees and executives typically understand their business better than anyone, and if they’re selling shares, it could be a sign they think the company’s future success is more than priced into the stock. Insider transactions are reported in filings with the Securities and Exchange Commission and accessible through the agency’s website.
But here again, there are exceptions to the rule. Insiders may sell for any number of reasons that have nothing to do with what they think about the company’s valuation. They may sell to cover taxes on a share grant they received, they could be rebalancing their overall portfolio, or they may just need the money for a purchase like a house or a car. Pay particular attention to sales made by the CEO, CFO or founder of the company. Sales by those individuals likely have more informational value than other employees.
Conversely, insider buying likely indicates that they believe the stock is attractive. While sales can happen for many reasons, executives typically buy for one reason: they think the stock is a good investment. Be sure to read filings carefully, though. An insider who is awarded shares as part of their compensation is not the same thing as an executive using their own cash to buy shares in the open market.
3. PEG ratio
The price-to-earnings growth ratio, or PEG, is a way to compare the P/E ratio to a company’s growth rate. A high P/E ratio for a fast-growing company may make a lot of sense, so it’s important to understand the growth outlook before making a judgment solely based on the P/E ratio.
A PEG ratio above 2 is typically considered expensive, while a ratio below 1 may indicate a good deal. As with any metric, the ratio is only as valuable as the information used to calculate it. If your projections about future growth are off, the ratio won’t have much value to you.
4. Economic cycle is about to turn
Some companies are cyclical in nature, meaning that their profits rise and fall with the overall economic cycle. These businesses can be some of the most difficult to value because they sometimes appear cheap based on ratios like P/E just as the economic cycle is about to roll over. Conversely, they can appear expensive when their earnings are depressed, which causes the valuation multiples to be inflated. But these depressed earnings may be at a trough in the economic cycle, the exact time when the stocks are most attractive.
If you find a cyclical business trading for a low multiple, make sure you consider the economic cycle and whether things might turn for the worse. An apparent bargain may actually be an overvalued stock.
Valuing a business is oftentimes more of an art than a science. But looking at valuation ratios, what company insiders are doing and where we are in the economic cycle can all provide clues as to whether a company is overvalued or not.
Remember that there is no magic formula when it comes to investing and you shouldn’t ever rely on just one or two metrics to make a decision. Work to understand a company’s future outlook and if you can’t reach a conclusion, you’re better off not owning the stock at all.