How to Spot an Overpriced Stock

After the past year's rally, many stocks have hit new heights. Shares of Apple (Nasdaq: AAPL  ) reached an all-time high of $219.70 on Friday, for example. But some investors fear that these dramatic increases may have left too many stocks overvalued.

Low-hanging fruit
While it's reasonable to wonder whether a high-flying stock is overpriced, we should keep in mind that companies' winning streaks can last a lot longer than many investors suspect. A grossly undervalued company might jump 20% over a short period and still be priced below its true worth.

Similarly, while it can be useful to note which companies are hitting all-time highs or 52-week highs, remember that any successful company will unavoidably hit new highs at various points during its shares' steady march. It might even set a new record every day for many days in a row.

The hard way
As investors, our primary job involves buying undervalued companies and (maybe) selling overvalued stocks. To make that call in Apple's case, we must first get a good handle on its true intrinsic value. A discounted cash flow analysis could give us a solid idea, but that complicated method relies on assumptions about future financial performance. Thankfully, there are easier ways to suss out a stock's true worth.

For the simplest -- and haziest -- estimate of intrinsic value, compare Apple's market capitalization to those of its peers. Market cap is the number of total shares outstanding, multiplied by the share price, which for Apple works out to just about $200 billion. That makes it smaller than Microsoft (Nasdaq: MSFT  ) and its roughly $250 billion market cap, but significantly larger than IBM (NYSE: IBM  )  at $165 billion, or Google (Nasdaq: GOOG  ) at $180 billion. In addition, Apple's market cap dwarfs those of non-technology names such as Coca-Cola (NYSE: KO  ) at $126 billion and McDonald's (NYSE: MCD  ) at $70 billion.

Does Apple really deserve to loom so large against big and ubiquitous companies such as Coca-Cola and McDonald's? A simple market cap comparison won't give you a definitive answer, but it will likely help you see whether the question deserves closer inspection.

Time to dig deeper
Once you're ready for a closer look, start with these steps:

  • Consider the company's competitive advantages, including its brand power, reputation for innovation, and a base of dedicated customers. With Apple, user-friendly creations like the new iPad have been crucial to its success.
  • Dig into the financials. Apple has almost $25 billion in cash and short-term investments, with no debt, healthy profit margins, and solid revenue growth.
  • Put the company's numbers in historical context. With a current P/E ratio of 27, Apple is roughly in the middle of its five-year range, which spans 12 to 39.
  • Check out commentary on the stock in Fool articles. Fool contributor Tim Beyers sees several ways for Apple to improve its prospects.  

Together, all this information begins to suggest that Apple's shares aren't wildly overvalued -- though they also don't seem to offer the huge margin of safety that successful value investors would seek.

Is Apple undervalued, overvalued, or just right? What stocks do you think are good values right now? Leave a comment below and share your thoughts.

Our Motley Fool Inside Value newsletter not only offers a scorecard full of great stock bargains, but also a handy DCF calculator to make crunching the necessary numbers as painless as possible.

Longtime Fool contributor Selena Maranjian owns shares of Coca-Cola, Apple, Microsoft, Google, and McDonald's. Coca-Cola and Microsoft are Motley Fool Inside Value picks. Google and VMware are Motley Fool Rule Breakers recommendations. Apple is a Motley Fool Stock Advisor pick. Coca-Cola is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.


Read/Post Comments (3) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 08, 2010, at 4:16 PM, BradApple wrote:

    When you consider the following facts, it's hard to see Apple as an overpriced equity:

    • Apple's average annual earnings growth over the past 5 years was 90.5%. (No, that's not a typo!)

    • Apple has a forward P/E ratio of 18 (or lower by some calculations).

    • Apple has only just begun to penetrate the Chinese market.

    • The soon-to-be-released iPad could well be a game-changing device for consumers, commuters and college students.

    • New MacBook Pros are expected later this year.

  • Report this Comment On March 08, 2010, at 6:33 PM, demodave wrote:

    I'm with Brad and I don't know for sure that citing Tim is particularly indicative of Apple's position. If you look at

    http://finance.yahoo.com/q?s=AAPL

    You find a P/E ratio of 21. The five year range may be 12 to 39, but I don't think that that is indicative of Apple's true range or value. In March of 2005, the P/E ratio was 46:

    http://ycharts.com/companies/AAPL/pe_ratio

  • Report this Comment On March 08, 2010, at 6:43 PM, stan8331 wrote:

    Apple isn't cheap right now, but underestimating that company can be very hazardous to your financial health. It wasn't all that long ago that Apple was a microscopic, near-bankruptcy speck of a lost company in comparison to the massive behemoth of Microsoft. Who knows where they may stand in comparison to each other ten years hence?

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