July 13, 2011 | In: General
When Is a Stock Overvalued?
Long term investors usually do some due diligence on a stock before buying it. This due diligence consists of knowing the long term technical information about the stock, informing themselves about the company’s business and potential future, and, of course, asking this question: Is this stock overvalued?
Knowing whether a stock is overvalued or not is critical to any long term (daytraders and short term investors don’t usually care about this) investor’s decision making for buying that stock.
So, when is a stock overvalued?
There are many signs that can tell us that a certain stock is overvalued, including, but not limited to:
Very high P/E Ratio: While a slightly higher than normal P/E ratio indicates that investors love the stock, a P/E that is extremely high is a sure indication that there are lots of investors who are just following the herd (e.g. buying the stock because everyone else is buying it or praising it). An example of a stock that has an extremely high P/E is LNKD: With a current P/E of 2,741, it will take LinkedIn almost 3,000 years to pay back investors! I’m not sure this whole world will still exist after 3,000 years, let alone the Internet (or LinkedIn, for that matter).
Stock price is moving up despite a general downtrend in the industry: While this may be perceived as “the stock is outpeforming the industry”, it may be very well the sign of a highly manipulated stock. One has to ask this question: What makes this stock so special and so good to move up while all the other stocks in the same industry are moving down?
The company is consistently issuing reports that are below analysts’ expectations, yet the stock is unaffected: Generally, when this happens, the stock goes considerably down, and is stuck in what I usually call “a bearish hell” until the company starts beating the analysts’ expectations. If you’re buying a stock issued by such a company, then rest assured you are buying an overvalued stock.
The whole company relies on a single person to move things forward: An example of such a company is Apple (Apple without Steve Jobs will be like a deliciously looking dish without salt – tasteless). What will happen to the stock if the person the whole company depends on is no longer there?
The stock is reaching an all time high nearly every month: Although it is nice to see that the stock you are about to purchase is consistently breaking new highs, you have to always remember the saying “what goes up must come down”.
The stock price is not factoring in unfavorable market conditions: Let’s assume, for example, that people no longer think that Apple products are cool, or that people start hating Netflix because they just increased their subscription by 60%. If negative market conditions surround the company, then the stock price should definitely drop.
The company is getting greedier by the day: Again, let’s take a look at the link to Netflix’s blog, they increased their prices by 60%. Now, while that may have a positive effect on the short term, people will become more disgruntled and Netlfix’s churn rate will skyrocket. Another good example (in the Canadian market) is TD Canada Trust. Me, as well as many other Canadians, are currently very unhappy with the bank sending us a letter every other day or so telling us that they’re increasing their interest rates or the fees (or even creating additional fees)1. Again, TD might go up on the short term, but eventually the churn rate that they will experience will catch up with their greed.
The company’s main product is not a serious product: There are many listed companies whose main products or services are not that important, or can be easily cloned. An example of such companies is Youku Inc. Its main product is a YouTube clone that is targeted at the Chinese audience, and that is plagued with copyright violations. There are just too many red flags about this service that makes YOKU way overvalued.
1You should read one of TD’s letters, they are making it look like they’re hiking their fees for our own good!
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