Undervalued vs. Overvalued Stocks: How to Differentiate

Last Updated: 8 Jul 2024

Price is what you pay and value is what you get is a popular piece of wisdom in the stock markets. Therefore, the key to smart investing in the stock markets is about finding stocks that are undervalued. This is where subjectivity comes in.

Your concept of value may not be the same as my concept of value. Flipkart may still be making mega losses but it was just sold for an insane valuation of $15bn. How do you justify that? The answer is you can’t. For now, let us forget outliers such as Flipkart. But how do you judge valuation under normal market conditions?

We will take the traditional line of argument here that any company’s value is determined by the free cash flows that it generates in the next few years. Let us look at five such measures that can help you differentiate between an undervalued and overvalued stock.

Price Earnings Ratio or Earnings Yield

Price Earnings or P/E ratio is one of the most popular methods of gauging the relative valuation of a stock. For example, a stock at a P/E of 10 needs to be looked at differently from a stock with a P/E of 25. Does this mean that a stock with P/E of 10 is undervalued and one with P/E of 25 is overvalued? Not exactly!

P/E should always be looked at with respect to growth, margins, and brand wealth. A company like Maruti may command a higher P/E just because it sustains growth momentum month-after-month. TCS may enjoy the highest P/E among large IT stocks due to the superior margins that it enjoys. Hindustan Unilever and Britannia may quote a fancy P/E ratios due to the strong brand value that they enjoy. Of course, at the index level, low P/E can be looked at as a sign of undervaluation and high P/E can be seen as a sign of overvaluation.

Another way to look at this ratio is to look at its reverse, i.e. the earnings yield (E/P). It is what the share earns in terms of net profits. This can be compared to the yields on debt. If the earnings yield on equity is higher than the yield on debt, then it does make a case of equity undervaluation.

Price to Book Value ratio

To gauge the valuation of a stock, the Price to Book Value (P/BV) ratio is a more selective and industry-specific measure. It calculates the stock price as a ratio of the book value of the stock (net worth). This measure is normally used in case of banks and financials, where the margins are normally stabilized and hence P/BV can be a fair gauge of valuation. Normally, a bank with low P/BV is considered undervalued.

EV/EBITDA as a valuation measure

How do you measure the valuation of a company if it is not making profits yet? Take the case of power companies, telecom companies, or even internet companies. They take years to turn around and claim profits. During this period, P/E cannot be a very good measure. The alternative is EV/EBITDA. The economic value (EV) is the market value of a company less its external debt. That is the price you pay to acquire the company. The earnings before interest, taxes, depreciation, and amortization (EBITDA) is a measure of profits of a company that is independent of the capital structure. Lower the EV/EBITDA, the stock is considered to be relatively undervalued. This measure is more useful for gauging undervaluation when a company is being acquired or merged.

Dividend yield as a measure of undervaluation

Can we use dividend yields as a measure of undervaluation? To an extent, yes! Dividend yield is the dividend per share divided by the price per share. If a stock quoting at Rs100 pays Rs5 as dividend, then the dividend yield is 5%.

Normally, the higher the dividend yield, lower is the valuation and vice versa. But this does not work very well in case of regular investing. That is because stock markets look at high-dividend-paying companies as cash cows that do not have too many growth opportunities.

Markets want growth and hence, the high dividend yield is not seen as too positive. However, dividend yield as a measure of valuation works quite effectively at an overall index (Nifty or Sensex) level, especially with the assistance of a stock market app.

Margin of safety of the stock

This is an offshoot of Warren’s Buffettology that has gained a lot of prominence in recent times. The margin of safety is the gap between the actual intrinsic value of a stock (arrived at by the analyst) and the actual market price.

Lower the stock price compared to the intrinsic value, greater is the margin of safety. Higher the margin of safety, more undervalued is the stock. This measure is useful because the intrinsic value of a stock tends to be a substantially subjective opinion. Hence it is always better to have a wider margin of safety.