How to check if a stock is overvalued or undervalued?

While investing in the stock market, 2 things are most important: fundamentals of the company and valuation of the company.

Ideally, you would want to invest in companies that are fundamentally strong and available at attractive valuations. In fact, there is a famous quote from Warren Buffett. He says, “Whether we’re talking about stocks or socks, I like buying quality merchandise when it is marked down.”

But the biggest question is - How to identify if the company is overvalued, undervalued, or fairly valued.

In this article, I will teach you how you can identify the valuation of a company in a few minutes. So let's get started.

Today, MRF share is available at Rs 82,000 whereas Apollo Tyre is available at Rs 225. Now, if I ask you which share is costly? Some of you might answer that MRF is very costly as compared to JK Tyre. Right?

That’s wrong. Many investors new to the world of the stock market end up deciding the valuation of the company based on the stock price which is wrong. So what is the right way to check the valuation of a company?

The most popular formula to understand the valuation of a company is the PE ratio. It is also known as Price to earning ratio.

Now let’s try to understand what exactly is this and why it is so important?

If I ask you - As an investor what are the most important criteria to gauge the performance of the company?

The answer is - Earning!

At the end of the day, you are interested to know how much profits the company has generated. Isn’t it? If the company is generating good profits then it is doing good and if the company is not able to generate profits then it is not doing good.

So the profits of the company should ideally decide whether you should invest in the company or not. If the profits are increasing, more people would be interested in investing in the company. This would increase the demand for the company and eventually the share price. If the profits are falling then people would like to sell their shares which would eventually increase the supply and low demand and result in a fall in the share price. 

In short, the share price should ideally move in relation to the earning. Hence, you have a PE ratio which is calculated as “Price per share” divided by “Earnings per share”.

In an ideal world, the share price should move with the earnings, but that doesn’t happen in the real world. Sometimes, the price goes much above even though earnings are not too high. This could be due to multiple reasons like macro environment including the government policy, lot of inflow of money or micro factors like expectations of better earnings in the future or sometimes just without any reason.

And sometimes, the price falls even though the earnings are good. For example, due to COVID, the market crashed and the share price of every company fell down irrespective of their earnings.

So let’s say if the price per share or share price of the company is Rs 150 and its earnings per share is Rs 5. Then you can say that the PE ratio of the company is 30.

In other words, you can also say that the investors are willing to pay Rs 30 per share for earning 1 Rs per share.
Tomorrow, if the share price of the company becomes 180 and earnings remains the same i.e. Rs 5 per share then the PE ratio would become 36.

And if the share price fall to Rs 125 and the price remains the same then the PE ratio would become 25.
Please note that the share price of a company changes every single day. Hence, PE will change accordingly. But the earnings change quarterly based on the quarterly results. Normally, the earnings are considered for the last 4 quarters. Many people get confused and consider the PE ratio based on the last financial year. For example, currently, we are in March 2021. Now we don’t have complete earning for FY21. It doesn’t mean we need to take FY20 earnings. We need to take the last 4 quarters of data. As of today, we have earnings till Dec 2020. So we need to take the last 4 quarters i.e. March 2020, July 2020, Sep 2020, and Dec 2020. This would give the latest PE ratio.

The next question is: How to know if a PE of 25-30-35 is overvalued or undervalued?

To get the answer to this question, you need to do 2 things. This is very important.

  • First, check the PE ratio of this company in the last 3-5 years and identify the median PE. Then compare the current PE with the median PE. If the current PE is more than the median PE, you can say that the company is overvalued. If the current PE is less than the median PE, you can say that the company is undervalued. Let’s take 3 real case example:
  • If we look at the ITC PE ratio movement, its median PE in the last 5 years is 30.7. Currently, it is trading at a PE ratio of 19.6. So ITC is trading at much lower levels as compared to its 5-year median PE. On July 17, it was at the PE of 41 but since then its PE has fallen. So ITC is looking undervalued at current levels.
  • If we look at the HDFC Bank PE ratio movement, its median PE in the last 5 years is 27.9. Currently, it is trading at a PE ratio of 26.7. So HDFC Bank is trading at similar levels as compared to its 5-year median PE. That makes HDFC Bank a fairly valued stock. During COVID, HDFC Bank's share price tanked and PE touched a level of 16.9 making it highly undervalued. That was a golden opportunity to invest. Although HDFC Bank is still a good buy at current valuation.
  • If we look at the Jubilant Foodworks PE ratio movement, its median PE in the last 5 years is 77. Currently, it is trading at a PE ratio of 227. So Jubilant FoodWorks is trading at much higher levels as compared to its 5-year median PE. That makes it a highly overvalued stock.
  • Secondly, you need to look at the PE ratio of the industry. For example, if Infosys is trading at a PE of 25 then what is the PE ratio of the entire IT industry. Ideally, there should not be too much of a difference if the companies are at par. For example, if you want to compare Infosys PE with Industry, you can look at the PE ratio of TCS, Wipro, and HCL that are at par with Infosys. This would give you an idea of the PE movement of the stock as compared to the other companies in the same sector.
Now, there could be a case where the PE ratio of some companies is on the higher side as compared to other companies. It is mainly because of their high earning potential in the future.

For example, let's say there is a company that is currently trading at a PE of 15 but the future of the company is not too bright. On the other side, there is a company that is currently trading at a PE of 50 but it is a relatively small company with amazing growth potential. Now, which one would you choose?

In that case, you should know the PEG ratio.

What is the PEG Ratio? 

It is calculated as PE divided by its future earnings growth. If company A has a PE of 15 but the future growth potential in earning is 5% then the PEG ratio is 3.
Whereas if a company B has a PE of 40 but the future growth potential in earnings is 20% then the PEG ratio is 2.

In this case, company B is undervalued as compared to company A even though the PE of company B is higher than company A.

Normally a PEG ratio of less than 1 is ideal. But it is extremely difficult to find a great company with a PEG ratio of less than 1. So you can consider a PEG ratio of less than 2 as undervalued or fairly valued. For example, ITC has a PEG ratio of 1.9, HDFC Bank has a PEG ratio of 1.3 and Jubilant FoodWorks has a PEG ratio of 10.3. So ITC and HDFC Bank are looking fairly valued and Jubilant FoodWorks is looking overvalued with PEG ratio as well.

Please note that if the earnings of the company are negative then you can’t use the PE ratio. I mean that if there is a company that is at a loss then you can’t calculate its PE ratio.
You can visit websites like a screener.in where you can get the details like PE ratio, PEG ratio, etc.

When PE doesn’t work?

Although PE ratio is the most popular and widely used ratio to gauge the valuation of a company, there can be instances where the PE ratio doesn’t work. Or rather, doesn’t show a clear picture of valuation. For example, due to COVID, the earnings of companies tanked. But, the prices increased in the last 1 year. In that case, the PE became very high. Now, in this situation, it is difficult to say that the company is overvalued or undervalued. It is because COVID was an exceptional situation and it has nothing to do with “company’s performance”. If the earning fall due to company performance then certainly there is a problem. But COVID was the external situation. For example, IRCTC is currently trading at a PE ratio of 130 but its median PE of the last 1 year is 68. But this high PE is mainly due to COVID where earnings of IRCTC fell down drastically and hence the PE went up.

So in that case, you need to look at future earnings. You need to think - What is the earning company will generate in the future. To do that, you can also take an average of historical earnings growth. So if the annual earnings of the company are 50 then 55 then 60 so you can say that company’s earnings are growing at 10%. And you can assume that the next earnings should be 66. But this is only applicable for companies whose performance gets impacted due to an external reason like COVID.

Please note that a PE of less than its median doesn’t always mean that the company is undervalued. There could be some problems within the company and hence investors are selling the share with the expectation that the earnings will fall in the future. Likewise, a company can have high PE than its median where investors are buying the share with the expectation that the earnings will increase in the future. So you need to make sure that that you do in-depth research and not just invest or exit simply based on the PE ratio.

PS: If you want to learn every aspect of fundamental analysis of stock and other important concepts of personal finance, you can explore my video course on "Everything about money management".

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