How to Know if A Stock is Overvalued or Undervalued?

In absolute terms, stock prices aren’t overvalued or undervalued. It is a relative terminology where an overvaluation or undervaluations happens for the stock compared to its peers.

Let us understand this with an example of what I mean an absolute terms overvaluation and undervaluation.

An investor is selling a stock at a price whereas the other investor is buying it. So the person who is selling the stock considers it to be a fair value or overvalued. So he is more than happy to sell the stock whereas the buyer considers there is still a lot of potential in the company and so stock prices appreciation will continue.

Let us now take a real-life example.

Promoters of Avenue Supermarts came up with an IPO at ₹300. They thought this is a good price to sell the stake in the company. They considered it to be fair valuation to sell the stock or it could be that they wanted to leave something for the investors as well.

There was a lot of interest in the stock at ₹300 and it listed at ₹600. Currently, it is trading around ₹1500.

Again many investors who considered ₹600 as a good price to exit thought it is a good enough listing gain and is now becoming overvalued. Results proved them wrong and stock just kept going rising.

Around ₹1400 Promoters again sold its stake because of the regulatory requirements that promoters can hold a maximum of 75% and the have more than 75%. Promoters thought this is a good price to sell the stake but those who purchased the stake considered it to be undervalued.

So overvaluations and undervaluations is a very relative term.

Overvalue and Undervalue Misconception

Overvalue Doesn’t mean the Stock will Correct Undervalue Doesn’t mean the stock will rise.

When I invested in Jubilant Foodworks in May-Jun 2016, I found it to be undervalued but currently, I think it is overvalued but that doesn’t mean the stock will correct. There are more buyers in the stock now then they were in 2016 and very few people who are holding the stock are willing to part away with it.

Similar is the story of many stocks whose PE multiple gone in 3 figures. Stock prices keep on rising despite some group of investors consider it to be overvalued because there are other sets of investors who consider it to be undervalued as yet.

The important word in the above statement is “as yet”.

Similarly undervalue stock doesn’t mean the stock price will continue to rise.

An overvalued stock doesn’t fall nor the undervalued stocks will start rising immediately. A stock becomes undervalued, it is for a reason that is more sentimental than fundamentals. People don’t want to be considering them and this is one of the reason there are no buyers for the stock.

How to Know if Stock is Undervalued or Overvalued?

If an investor can buy an undervalued stock, he or she can make lot more money but the problem is to keep believing in what you have invested is an undervalued stock and there is no problem in holding the stock.

The good news for the stock can keep on coming but the price correction can continue creating a doubt in the mind of the investor if he has made the right decision or not.

An example I can share is of Amara Raja Batteries. The stock is down 30% from its all-time peak. There is no bad news for the company. The results are good, the sales are ever increasing. The auto sector is seeing good sales and growth. They are market leaders with duopoly (they are not the only player but there are 2 major players. Other one being Exide Industries).

The only reason for the stock to go down is, there are so many sellers in the stock that it isn’t able to get a decent rally either despite all the good news. As an investor one may think, is there anything that he or she doesn’t know that market knows?

PE and EPS based Overvalued and Undervalued Stocks

Earnings are one of the common factors to consider valuations and so a common consensus is to the use earnings per share or EPS and price to earnings or PE ratio of the companies to determine the stock is overvalued or undervalued.

So if the stock’s EPS is ₹10 and if the stock is trading at ₹300, the PE ratio is ₹300/₹10 which is 30.

So if the average PE ratio of all the companies in the similar business is taken, it is known as the sectorial PE ratio or industry PE ratio.

Now if the company is available at a discount to the industry PE is considered to be undervalued otherwise it is overvalued.

Historical PE to Find Overvaluation and Undervaluations

It is a good estimation if you are able to find companies in similar business but my most important investment checklist criteria are to invest in unique businesses. So I don’t like the above method of calculation of overvaluation or undervaluation based on peer’s PE ratio because in unique businesses you don’t have any peers in a true sense.

So let us take an example of my investment in Pidilite Industries. It is quite a unique business in its own way still it is considered operating in the Speciality Chemical Industry and has the highest PE in the industry. I still considered it to be a good investment of around ₹700.

So though overvaluation and undervaluation may be good when compared with the peers, it is better if you consider the overvaluation and undervaluation based on the companies historical PE ratio.

There is a second school of thoughts about overvaluation and undervaluations. So if the stock’s historical average PE ratio was 40 and if the company is now available at a PE ratio of less than 40, it can be considered as an undervalued stock.

The only problem is, in a bull market like India, you won’t find such contracting PE ratio but only in the phase where either the stock or the sector is going through some correction that you will find such undervalued stocks that are available at lesser PE multiple ratios than their long-term average PE ratio.

The examples currently can be taken from pharma sector which is available at quite a lower PE ratio from their historical PE or one can give an example of Nestle India when it had all the Maggi related issues it was available at lesser PE ratio than its historical PE ratio average.

Here is the historical average price PE ratio of Glenmark Pharma from ValueResearchOnline.

The PE ratio is the earnings company has already done but a more important aspect to investing is what the company will be able to do it in the future. So PE ratio may be a good indicator of the past earnings but as an investor one should consider the future earnings.

So this is where the analysis of the projected earnings comes into the picture and people derive valuations based on the earnings company is expected to report.

How I Calculate Overvaluations and Undervaluations?

When you only want to consider the unique kinda business, you will not find them for a cheaper price to earnings ratio for sure and this is one thing I have realized. So PE ratio isn’t something I use to determine overvaluations or undervaluations.

Similarly, for stocks to be available at a lower than it’s historical PE can mean one may have to wait for a very long time. I believe in this quote.

Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves. – Peter Lynch

So instead of waiting for the stock to be available at a historically lower PE, I decided to use a simple yet effective formula to know what is the time when the company will be able to make its earnings equal to the price I am paying for it now and if it is the timeframe I will willing to remain invested in the stock, I can go for it.

So let me share this with an example of some of the overvalued stock based on PE and historical PE stocks that I own in my portfolio. Based on its current EPS and past 5 Years of EPS growth, how many years will it need for the company to get to the WPD is equal to the price I am paying today.

The formula to calculate the time is from the compound interest formula:

Where: t = log(A/P) / n[log(1 + r/n)]

But I use Calculator Soup to input the values and get the time.

Note1: The price I have used in the above table is the price I have paid for the stock when I added them to my portfolio. So it is only for the calculation for the sake of understanding the process and is not a recommendation of any stock.

The EPS and 5 years EPS growth value is from Investello.

Only from a PE point of view, Pidilite is trading at 50x and Page Industries at 80x but consider the past 5-year average growth for both the companies, both will need 20 odd years to get EPS at that price. Zydus Wellness is trading at 30PE but will need 35+ years because of its lesser growth number.

This is also one of the factors why good growing companies have much higher PE ratio.

So based on these, one can see how much time a company needs to reach to the earnings per share you are paying the price right now. The smaller the time frame the better.

This is based on the earnings per share for the stock but one can also apply the same formula for the growth in book value as well. The time a company will need for the book value to reach the price you are paying now.

This method can be an indicator to understand the price you are paying for a share.

Final Thoughts

There is no full proof formula for overvaluation or undervaluation and even the above method isn’t ideal.

Wrong Growth Estimation: You are taking into account the past growth and extrapolating it for the future. It may work on certain type of companies only. As an example, the Pharma sector is considered as an undervalued sector but that may not be the case with such calculations because we are interpolating the past growth into the future but it may be a wrong estimation of growth.

Cyclical Businesses: The other issue is, it may not work on all kind of businesses especially the cyclical businesses where the growth in EPS isn’t uniform over an elongated period of time. In the commodity up-cycle, the growth is higher and reduces in the commodity down-cycle. Because I invest majorly in monopoly type businesses (my business checklist) and avoid commodity type companies, it works well for me.

If you prefer investing in cyclical, you have to create your own way of evaluating them as overvalued and undervalued.