A stock can become overvalued when the price of a security becomes detached from its underlying fundamentals. In the short run, stocks can stray far from their intrinsic value, but in the long run, they will eventually move back closer to the true value of the underlying company.
Sometimes, this results in an opportunity to buy undervalued stocks, but it can also swing the other way. If you buy an overvalued stock, it will likely end up underperforming the market as the price eventually falls back to its real value.
What is it?
What is an overvalued stock?
An overvalued stock is one that trades at a price significantly higher than its fundamental earnings and revenue outlooks suggest it should. It may also trade at a price-to-earnings (P/E) multiple higher than its peers when adjusted for future growth.
Related: What is a story stock?
Is it overvalued?
How to determine whether a stock is overvalued
You can use a variety of metrics to assess a stock's value. Two of the most common are the P/E ratio and the enterprise-value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio, or EV/EBITDA. Both are measurements of the current stock price versus the underlying company's earnings or earnings potential.
It's also important to consider a company's future earnings growth. All else being equal, a fast-growing company absolutely should trade at a higher earnings multiple than a slow-growing company. Some investors look at the price/earnings-to-growth ratio (PEG ratio) as another indicator of whether a stock is overvalued.
The best way to determine whether a stock is overvalued is to dig into the company yourself. Make your own estimates for its future revenue growth, margin expansion (or compression), and how it all affects the bottom line. Sometimes, you might find something the rest of the market is missing.
The most overvalued
The most overvalued stocks
Here are three overvalued stocks:
1. Arm Holdings
Arm Holdings (ARM -0.52%) develops the central processing unit (CPU) architecture and intellectual property (IP) used in smartphones, tablets, and a growing number of data center servers. It doesn't produce chips itself but rather takes a royalty on each chip sold that licenses its designs. That royalty rate has steadily climbed over the last few years.
Increased royalty rates for its v9 architecture have supported strong revenue and earnings growth recently, but it's unclear whether the market can support further increases in royalty rates. Arm's customer concentration is a concern, with 54% of sales coming from its top five customers, including Arm China.
With a forward P/E above 80, the stock is priced for considerable growth. But to get there, it'll have to keep raising royalty rates without losing market share. Expectations for the business do not line up with the stock valuation.
2. Dick's Sporting Goods
Dick's Sporting Goods (DKS 0.26%) is a sporting goods retailer that has seen a lot of momentum over the last few years. It benefited greatly during the COVID-19 pandemic, seeing earnings per share (EPS) soar to $15.70 in 2021.
That drove its stock price considerably higher, but the market may have gotten ahead of the business. Management's guidance going forward is for just 2% to 3% EPS growth on the back of 2% to 3% in same-store sales growth.
A big challenge facing Dick's is a growing penchant from vendors like Nike (NKE 0.53%) and Adidas (ADDYY 0.29%) to sell directly to consumers instead of wholesale to retailers. Meanwhile, Dick's has little means of driving additional traffic to its store.
Despite a forward P/E of about 17, the stock isn't a good value. When you compare it to other slow-growing specialty retailers, it's trading at a valuation well above comparable store brands.
3. Wingstop
Wingstop (WING -1.62%) stock has been on fire, as its hot-wing restaurants produce extremely strong results. The company is seeing same-store sales growth accelerate as more and more customers flock to its restaurants.
While the business is expanding quickly, producing strong top and bottom line growth, investors should be concerned with Wingstop's valuation. The stock trades for more than 100 times its forward earnings estimates. Its price-to-free-cash-flow ratio also exceeds 100. The valuation is double that of the fast-growing, super-popular Chipotle Mexican Grill (CMG -0.61%).
Despite the restaurant chain's phenomenal growth, it's hard to justify the current share price as a fair value.
Related investing topics
Don't overpay
How to avoid overpaying for a stock
Even a great company can have an overpriced stock. Analyzing the business can save you from making an investment that underperforms the market, even if the company continues to perform as expected.
As famous value stock investor Benjamin Graham said, in the long run, the stock market is a weighing machine. Eventually, prices move toward their intrinsic values.
