Overvalued Stocks Explained: Definitions, Examples & Investment Strategies

What Is "Overvalued"?

An overvalued stock is one whose current market price exceeds what its earnings outlook or fundamentals, often assessed using metrics like the price-to-earnings (P/E) ratio, can justify. Overvaluation can stem from factors such as investor enthusiasm, market speculation, or temporary shifts in company performance.

While analysts generally expect such prices to correct over time, overvalued stocks can present opportunities for certain strategies like short selling. Views on whether markets efficiently price stocks vary, making overvaluation a debated but crucial concept for investors to understand.

Analyzing the Fundamentals of Overvalued Stocks

Some market theorists believe that the market is naturally perfectly efficient. They argue that fundamental analysis is pointless because the stock market already knows everything. Thus, stocks might not be truly undervalued or overvalued. Contrarily, fundamental analysts are staunch in their belief that there are always opportunities to ferret out undervalued and overvalued stocks because the market is as irrational as its participants.

Overvalued stocks are ideal for investors looking to short a position. This entails selling shares to capitalize on an anticipated price declines. Investors might trade overvalued stocks at a premium if the brand or management boosts their value.

Identifying Overvalued Stocks: Key Metrics and Strategies

Relative earnings analysis is the most common way to identify an overvalued stock. This metric compares earnings to some comparable market value, such as price. The most popular comparison is the P/E ratio, which analyzes a company's stock price relative to its earnings.

Analysts looking for stocks to short may seek overvalued companies with high P/E ratios, particularly when compared to other companies in the same sector or peer group. For example, assume a company has a stock price of $100 and earnings per share of $2. Its P/E ratio is calculated by dividing the price by the earnings ($100/$2 = 50). So, in this example, the security is trading at 50 times earnings.

If the company's EPS rises to $10, the new P/E ratio would be $100 divided by $10, which equals 10.  Most people would consider the company to be overvalued at a P/E of 50, but possibly undervalued at 10.

Real-World Example: Analyzing Overvaluation

Although by definition, a stock is overvalued only by the opinion of an analyst, The Motley Fool website is never shy about weighing in. For example, they deemed the pharma giant Ely Lilly to be overvalued because the company's valuation reached "untenable levels following the company's meteoric rise during the tail end of 2019 and early days of 2020."

According to The Motley Fool, in January 2020, the company's stock was the second most expensive among its industry peers and Eli Lilly might find it hard to deliver consistent expected growth.

The Bottom Line

Overvalued stocks are those considered overpriced because their market value exceeds what earnings projections and key metrics like the P/E ratio would justify. Such overvaluation often comes from emotional trading or weak fundamentals, creating inflated prices that may eventually correct.

These situations can create opportunities for short sellers who anticipate a decline in value. Investors often rely on the P/E ratio and compare it to industry peers to identify potential overvaluation. For example, Eli Lilly's stock has at times been cited as overvalued based on such analysis, underscoring the importance of careful valuation assessment.