Undervalued vs. Fully Valued vs. Overvalued – What’s the Difference?
How to Tell if a Stock is Undervalued, Fully Valued, or Overvalued
One of the most important things to know as a trader or investor is how to tell if a stock is undervalued, fully valued, or overvalued.
The entire premise of a lot of investing is knowing value.
Whether you’re buying a stock, a home, or some other asset, what you pay is one of the biggest determinants of your eventual returns.
After all, you don’t want to overpay for a stock or anything, but you also don’t want to miss out on a good deal.
So, how can you tell the difference?
Let’s give a brief overview of each.
Undervalued Stocks
An undervalued stock is, simply, a stock that is trading for less than it is actually worth, which is likely to be realized in the future through price appreciation..
There are a number of reasons why a stock might be undervalued, such as poor recent performance, lack of analyst coverage, or negative news headlines.
Sometimes markets get out of whack for liquidity purposes.
However, just because a stock is undervalued doesn’t necessarily mean it’s a good investment.
You still need to do your due diligence to make sure the company is in good financial shape and has a solid business plan.
Sometimes there are legitimate reasons why stocks are undervalued. For example, in China, similar companies tend to trade at lower multiples than those in the US.
This is often due to factors such as regulation, uncertainty as to how receptive the government is to profit-making beyond a certain level, and investors not having an easy time moving their money in and out of the local markets.
Fully Valued Stocks
A fully valued stock is a stock that is trading at approximately the same price as what it is actually worth.
In other words, there is no real discount to be had.
This doesn’t mean the stock is necessarily overpriced, however.
It could just mean that the market has already priced in all of the positive news and expectations for the company.
Fully valued stocks are more common than undervalued or overvalued stocks. This is because it can be difficult for investors to agree on the true value of a company.
It’s not at all easy to spot a mispricing in markets.
Many will buy fully valued stocks because:
- they believe it’s a great business to own
- they don’t time the market and just want to invest their savings (e.g., dollar-cost averaging)
Overvalued Stocks
An overvalued stock is a stock that is trading for more than it’s actually worth.
This can happen for a number of reasons, such as too much hype, analyst upgrades, short squeezes, easy monetary policy leading to manias, bubbles, overvaluation, and so on.
Overvalued stocks are often the result of investor speculation or irrational exuberance.
As with undervalued stocks, you need to be careful with overvalued stocks.
Just because a stock is overvalued doesn’t mean it’s necessarily a bad investment, but you do need to make sure the company is in good financial shape before buying.
While an overvalued stock might go up in the short term, it’s likely to come crashing down eventually. That’s why it’s important to be careful when investing in overvalued stocks.
Methods of Determining Whether a Stock or Asset is Undervalued, Fully Valued, or Overvalued
There are a few main ways:
Discounted Cash Flow Analysis
You can use this method to estimate the intrinsic value of a company by discounting its future cash flows.
Comparable Companies Analysis
You can compare the stock price of a company to similar companies in its industry.
You will then look at average valuation multiples to get an idea of where a company or asset should trade.
Common valuation multiples include P/E, P/S (common for high-growth firms), EV/EBITDA, and more.
You can find these ratios on many financial websites or by looking at a company’s financial statements and calculating them on your own.
Precedent Transactions Analysis
This method looks at past transactions of similar companies to value a company today.
For example, if Twitter was being valued, an investor might look at the past acquisition prices of similar companies like Tumblr or Instagram.
The main drawback of this method is that it’s difficult to find perfect precedents, so it’s often combined with other methods.
Now that we’ve looked at some methods, let’s look at an example.
The important thing is to use multiple methods and come to an overall conclusion.
It’s rare that a stock is perfectly undervalued or overvalued – usually, it falls somewhere in between.
From there, you can decide whether or not to buy.
Can you also do this with private assets that are not traded on public exchanges?
Yes, we have a bit about that below.
Related: How to Value Private Companies?
Warren Buffett: How to Know if a Stock is Undervalued
FAQs – Undervalued vs. Fully Valued vs. Overvalued
What is an undervalued stock?
An undervalued stock is a stock that is trading for less than it is actually worth.
What is a fully valued stock?
A fully valued stock is a stock that is trading at approximately the same price as what it is actually worth.
What is an overvalued stock?
An overvalued stock is a stock that is trading for more than it’s actually worth.
What are some risks associated with buying overvalued stocks?
While an overvalued stock might go up in the short term, it’s likely to come crashing down eventually if the price is out of whack with its fundamental value.
Moreover, the price also tends to get bid up when many people hear about a certain asset going up simply because they extrapolate and believe the momentum in the market makes it easy money.
That’s why it’s important to be careful when investing in overvalued stocks.
How do you determine whether stocks are undervalued, fairly valued, or overpriced?
There are a number of different methods you can use, such as price-to-earnings ratios, price-to-sales ratios, and so on.
You can also use discounted cash flow analysis to estimate the intrinsic value of a company. The important thing is to use multiple methods and then come to an overall conclusion.
It’s very rare that a stock is either perfectly undervalued or perfectly overvalued. It’s more likely that the stock is somewhere in between.
Should you buy stocks when they are underpriced, fully priced, or overpriced?
The key is to buy stocks when they are undervalued and sell them (or avoid buying them or take proper precautions) when they are overvalued. Of course, that’s easier said than done.
It takes experience to be able to value stocks correctly.
One final word: don’t get too caught up in trying to value stocks perfectly.
No one can do that. And prices are always moving. Most valuations should be expressed within a range, not a down-to-the-cent type of price, which doesn’t make any sense.
The important thing is to have a general idea of whether a stock is undervalued, fully valued, or overvalued.
From there, you can make a decision on whether or not to buy. You can never time things perfectly.
What are some risks associated with buying overvalued stocks?
While an overvalued stock might go up in the short term, it’s likely to come down eventually.
That’s why it’s important to be careful when investing in hyped up and overvalued stocks.
Conclusion
As a trader or investor, it’s important to know how to tell if a stock is undervalued, fully valued, or overvalued.
There are a number of different methods you can use, such as price-to-earnings ratios, price-to-sales ratios, and so on.
You can also use discounted cash flow analysis to estimate the intrinsic value of a company by projecting revenue and expenses, then discounting the earnings back to the present.
It’s ideal to use multiple methods and then come to an overall conclusion.
It’s very rare that a stock is either perfectly undervalued or perfectly overvalued.
It’s more likely that the stock is somewhere in between.
One final word of advice: don’t get too caught up in trying to value stocks perfectly.
No one can do that.
The important thing is to have a general idea of whether a stock is undervalued, fully valued, or overvalued based on your personal goals.
From there, you can make a decision on whether or not to buy.