Three quick ways to find out if a stock is overvalued

Deciding what stock to buy can be a challenge especially in a bullish market. Bullish markets are characterized by higher returns on the average for equities as well as increased liquidity in the market. This can sometimes result in overpaying for a stock or underpaying depending on which way the pendulum swings.

Luckily, there was snap analysis you can do with the help of a calculator to determine whether a stock is expensive or cheap. Of course, a stock being expensive or cheap is relative to the buyer or seller as other factors are involved but these tried and tested methods are perhaps the most widely used out there.

Price Earnings Multiple

Definition – This is probably this most used financial terminology in the stock market and one of our favorites. It is simply the share price of a stock divided by its earnings per share.

Market use – The P/E Multiple for short indicates just how much more investors are willing to pay in multiples of the current earnings per share of a company. For example, if you own a business that is just earned you a profit of N1million and you place a P/E multiple of 10x to it, you are basically telling a potential buyer that your company is worth N10 million. The buyer can look at your offer and decide 15x is either too much or too small.

Why it matters – Price Earnings Multiple is a snap way of valuing a company and is mostly reflective of market sentiments. During the downturn of 2015-16, price-earnings multiples for most stocks in Nigeria were as low as 4x. As an investor, you should look at the P/E multiple of a stock and compare it to others within its sector to determine if it is hugely overpriced or severely underpriced.

A misconception – Some people believe that a low P/E ratio means a stock is cheap or that a high one is expensive. Sometimes it is but only if you compare it to something. You can either compare it to the P/E of its peers or to the market or to its growth rate. If you always remember that P/E ratios are reflective of market sentiments at any point in time, then you avoid falling into this trap.

Price to book ratio

Definition – This is the ratio of the share price of a company to its average net asset per share.

Market use – Another common term but often viewed with less importance than the price-earnings ratio. The price to book ratio helps a discerning investor determine just how high or low the market prices the stock of a company relative to its total shareholder funds or net assets.

Why it matters – A higher price to book ratio is sometimes assumed as being expensive. This is because the market is suggesting that it values a stock much more than what its value is on paper. Not a bad assumption but it can be misleading. That you own a car and a house does not mean I will buy them at the value you bought them the first time. However, it could matter if the house is worth more in the market than how much you originally paid for it.

Price Earnings Growth

Definition– This is the price-earnings ratio of a stock divided by its earnings growth. It is one of my favourite metrics.

Market Use – The PEG ratio as it is widely called is built to address the issues inherent in using price earnings ratio only. If a stock is priced at 10x its earnings and it is growing its earnings at 5% historically then the PEG ratio is 2x. By adjusting for the earnings growth, you can determine if the market is oveboard with its valuation or assigning multiples for factors other than the fundamentals of the company.

Why it matters – Most investors believe PEG ratios of equal to or less than 1 suggest the stock is cheap. So, if a stock has a price-earnings multiple of 30x and the latest earnings per share show an earnings growth of 40%, then it means the earnings are growing at a faster rate than the multiples the market placed on it.

The data you use for computing these figures can be found on the Nigerian Stock Exchange.