Undervalued Vs. Overvalued Stocks

Investing in undervalued stocks is sometimes a profitable strategy.

Investing in undervalued stocks is sometimes a profitable strategy.

Warren Buffett, as a brilliant stock-picker, staked his reputation on favoring value stocks and purchasing shares in companies he saw as priced below their true value, while generally avoiding investments in overvalued stocks. His Berkshire Hathaway stock portfolio consistently outperforms the broad market, so a strategy that works for Buffett just might work for you.

Valuing Stocks

A key data point that analysts use to determine whether a stock is under or overvalued is its price to earnings (P/E) ratio. To determine the ratio, take the current stock price, or its market value per share, and divide it by the company’s annual earnings, or the earnings per share. Another data point -- the PEG score -- consists of the P/E score divided by growth rates.

Factors

Stocks with a low P/E ratio or PEG ratio may be considered value stocks. Higher P/E ratios might indicate a company expected to achieve high growth, which would categorize it as a growth stock rather than a value stock. A high P/E ratio also serves as a possible sign of overvalued stock. A PEG ratio below 1 could indicate an undervalued stock, while a ratio over 1 might signal an overvalued stock. Compare P/E and PEG ratios to competitors or other similar industry stocks, rather than to the broad market, as some industries tend to have higher or lower overall valuations than others.

Finding Undervalued Stocks

Most online brokerage firms have stock-screening tools available to the general public. Even if you don't have a brokerage account with the firm, such tools can help you determine which stocks to avoid. Some value stock investors look at entire industries currently out of favor or at companies that have experienced recent troubles. For example, some non-high tech stocks became relatively undervalued during the dotcom boom from 1999 to 2000. Another example would be Toyota in the months that followed safety recalls in 2009, when its stock price tumbled.

Beyond Valuation

While valuation rates as an important factor in stock picking, it isn’t the only consideration. Even Buffett advises that “it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price.” He does seek high returns by purchasing undervalued shares, but he also sticks to solid companies. In addition to looking at valuations, investors should look for creditworthy companies with strong profits and profit potential. Take care, however, before buying overvalued stocks -- the higher they are, the harder they could fall.

 

About the Author

Annabella Gualdoni has written newsletters and reports for corporations and nonprofits since 1994. She is a real estate professional and also teaches subjects including international cooking and travel, dating/relationships and personal finance. Gualdoni has a Bachelor of Arts in international development from University of California, Berkeley, a Master of Arts in international relations from Boston University, and a Juris Doctor from Boston College Law School.

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