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What is Undervalued and Overvalued Stocks

The stock market is one of the most interesting platforms, where people can enjoy investing and earning profits.

However, there are multiple technicalities that are involved, and for an individual to be able to succeed in the share market, will have to have proper insights and understanding of the terminology which includes undervalued, overvalued stocks, etc.

If you have invested in the stock market, you might be familiar with the “buy low sell high “strategy. It means that buying the stock at the right time means finding the undervalued stock and selling them as soon as it is overvalued; however, this is not a piece of cake.

Analyst spends their life analyzing the undervalued and overvalued stock they use valuation models for stock analysis and accordingly provide consultation. However, it is imperative to determine the stocks rightly if you want to succeed in the stock market.

E.g., a company named XYZ was trading for $10 per share in the last month and is now priced at $30.

Do you think it is the right time to sell the stock?

Maybe yes or maybe not?

We cannot assume that just because the price of the stock reached 10 to 30 means it is overvalued unless and until we know everything about the business. Even if the share prices increase four times, the company share can still be undervalued the business has potential.

Before buying a stock, you must consider the company’s character, like how long is the company going to last or what are the risk factors. For generating assets, these points must be taken into consideration. Stock market apps can also help you to invest wisely

If you don’t know how to analyze a stock and see whether it is overvalued or undervalued, don’t worry; we are here to help; in this article, we will see how that can be done.

Price to Earnings Ratio

To know the proper value of the stock, one of the most critical metrics is the price-to-earnings ratio; it is straightforward to calculate.

Divide the stock price by 12 months (trailing earnings per share), e.g. if a stock is trading at$10 and its earnings in the 12 months were $2, its P/E ratio will be 20.

Comparing P/E Ratios

In order to invest in the best stock to get maximum earnings, it is imperative to compare the P/E ratio. Compare the P/E ratio of other companies operating in that industry and know the average PE of that industry.

Suppose all the companies operating in that segment have an average P/E of around 30 but the stock you are going to invest in has a P/E ratio of 20 then the stock you are planning to buy is undervalued. If the average p/E of the industry is lower than the company P/E ratio, it is overvalued stock.

However, there are some exceptions to this as well.

Research Low P/Es

A company giving an allowed P/E maybe sometimes undervalued, or there might be a reason for its low valuation. Suppose the company is suffering from legal or labor problems or financial troubles.

The reason behind the low P/E ratio can be many, and not only that it is undervalued. It is imperative to research appropriately the reason behind the stock being undervalued. You can refer to the media and news restless on the company website to know about the other reasons.

High as a Buy

A high P/E does not necessarily mean that the stock is overpriced. The reason could be different, e.g., it might be company suffered a one-time loss that is unlikely to be repeated or might be some temporary problem impacting the earning.

The company might also have a high P/E as it is expected to have very high future growth. If the company has launched a new product that has very high potential and is expected to increase revenue, the high P/E ratio is justified. Hence it is imperative to look at the forward P/E ratio of the company.

Forward P/E

To get a clear understanding of the undervalued and overvalued stock, divide the forwarded P/E price per share by its expected future earnings instead of current earnings. However, it is imperative to get adequately estimated earnings from an expert industry analyst; you can take the help of stock market apps for this.

The Difference Between Price and Value

You must understand before investing the actual value of the stock. Keep in mind that there’s a difference between the price and the value of the stock. The stock price doesn’t need to reflect its actual value.

Let’s understand these conditions which you may come across while investing.

  1. Price > Value.

 In this condition, the stock price is high than its value, which means it is overvalued.

2. Price = Value.

 In this condition, the price of the stock is equal to its value, and you would be able to buy the stock at its intrinsic value.

3. Price < Value.

In this situation, the stock price is lower than its value, which means that the stock is undervalued.

After reading this article you will be able to identify the undervalue and overvalued stocks.

Ajeet Sharma, the founder of Financegab and a well-known name in the field of financial blogging. Blogging since 2017, he has the expertise and excellent knowledge about personal finance. Financegab is all about personal finance which aims to create awareness among people about personal finance and help them to make smart, well-informed financial decisions.


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