Q&A with David Edwards: How do I know if a stock is overvalued?

Question: To find the price-earnings ratio of a stock, I divide the current stock price with the last four quarters of earnings. If the current list price is higher than the number I get when I calculate the P/E ratio, what does that mean? Is the stock overvalued?


Answer: The answer of course is, "it depends". For example, the price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple. 

The P/E ratio is only one tool for evaluating a stock's valuation. But it's a good starting point if you are interested in learning about stock valuation. We use about 10 valuation ratios and 5 technical ratios in evaluating stocks for our portfolios. We actually prefer stocks with low P/S (Price/Sales) ratio and high operating margin (e.g. Apple).

Simply calculating the P/E ratio won't tell you much. You have to compare the P/E ratio of the company you are investigating to the company's industry group, market sector and the overall stock market. 

The company valuation tab in Morningstar will give you the comparable data by industry group and overall stock market. This free resource from CSI Market is a little hard to sleuth through but will give you the comparable data by industry group and sector (click on the valuation tab). Another helpful tool is the Boston Consulting Group matrix that divides companies into four types: stars, question marks, cash cows and dogs.


Stars, Question Marks, Cash Cows and Dogs

Stars have a High Market Growth Rate and High Relative Market Share (e.g. Amazon). These companies typically have high P/E ratios.

Question Marks have a High Market Growth Rate, but Low Relative Market Share (e.g. Nokia). These companies typically have lower P/E ratios than their industry group average, or N/A if the company is making losses.

Cash Cows have Low Market Growth Rates but High Relative Market Share (e.g. McDonald's).  These companies have P/E ratios close to the overall stock market, but higher than peers.

Dogs have Low Market Growth Rates, and Low Relative Market Shares (e.g. SuperValue Groceries). These companies typically have lower P/E ratios than the overall stock market and their industry group average, or N/A if the company is making losses.

In general, P/E ratios will be higher in the fast growing technology sector and lower in the slow growing consumer staples sector. P/E's will expand when the economy is doing well, but interest rates remain stable. P/E ratios fall when interest rates are rising.


PE/G Ratio

You can also apply the PE/G ratio. The price/earnings to growth ratio (PE/G ratio) is a stock's price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PE/G ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio.

Take the trailing P/E ratio, and divide by analysts' average estimates of forward growth. If the ratio is less than 1 (e.g. a P/E of 15 divided by a forward growth rate of 20% = 0.75) then the stock offers "Growth At a Reasonable Price" or GARP. In the current environment, very few stocks have a PE/G ratio less than 1, implying that most stocks are fairly or overvalued.



You can subscribe to Morningstar. Their research process will give you a range of "fair value" stock prices, including the prescription to buy at this level and sell at that level. Most stocks in their database fall into the "fair value" range, which makes sense. Other investors will aggressively buy an undervalued stocks and aggressively sell an overvalued stock, driving prices back into the range.


Do you have more questions?
Feel free to contact me.

David Edwards, President
Direct: (347) 580-5281