Investors usually make buy and sell decisions based on stock prices -- ideally, buying undervalued stocks and selling overvalued stocks. However, figuring out the true value for a stock is difficult. Stock prices usually depend on profits. Strong and rising profits usually mean rising stock prices, while weak and falling profits mean declining stock prices. Use technical charts, market sentiment and historical profits to determine if a stock price is overvalued or undervalued.
Find the price-to-earnings ratio, which is widely published for individual stocks and broader markets on Yahoo! Finance, MSN Money and other financial websites. The P/E ratio of a stock is equal to the price divided by the earnings per share, which is the net income minus preferred dividends, divided by the number of outstanding shares.
Compare the P/E ratio of a stock to its industry peers and the overall market. A stock that is trading at a comparatively lower P/E ratio than its peers or the broader market could be undervalued, while a stock trading at a higher P/E ratio could be overvalued. However, a stock price might be low because the company is in serious financial trouble, reports John W. Schoen of MSNBC.
Evaluate the valuation of broad market averages. Yale professor Robert Shiller uses historical earnings of Standard & Poor's 500 stocks to determine if the broad market is undervalued or overvalued. The S&P 500 is a broad measure of 500 large U.S. public companies. According to the Wall Street Journal, Shiller used this method to correctly predict the 2000 tech crash and the 2006 housing crash. A pricey market can still trade higher, but at least you can exercise some caution in your individual investment decisions. Similarly, a falling market can continue to fall before stabilizing and trending higher.
Consider both sales and earnings, suggests SmartMoney magazine columnist James B. Stewart in a February 2011 Wall Street Journal article. Earnings are important, but companies that demonstrate healthy year-over-year revenue growth are more attractive. He uses a P/E threshold of 14 to determine overvaluation or undervaluation. Companies that have higher growth rates, such as new technology companies, tend to have higher P/E ratios.
Assess the market sentiment. Scan through news stories and listen to stock analysts on various business media outlets to get a sense of it. Pervasive gloom and doom might indicate undervaluation, while a sky-is-the-limit euphoria could indicate overvaluation. However, research cited by Wall Street Journal reporter Jonathan Clements indicates that market timing is a risky strategy that rarely outperforms a patient buy-and-hold strategy.
Use technical analysis, which forecasts future price trends based on historical data. Relative strength index is a common technical indicator, which measures the speed and change of stock price movements on a scale of zero to 100. According to Bullseyestox.com, an RSI above 70 indicates overvaluation and an RSI under 30 indicates undervaluation. Yahoo! Finance, MSN Money and other financial websites provide free technical analysis tools.
- MSNBC; When Is a Stock 'Undervalued'?; John W. Schoen; September 2003
- "The Wall Street Journal"; Is the Market Overvalued?; E.S. Browning; April 2011
- "The Wall Street Journal"; It's Time to Focus on Revenues; James B. Stewart; February 2011
- "The Wall Street Journal"; After 13 Months of Plunges, Reasons to Return to Stocks; Jonathan Clements; May 2001
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.