How to Know if Stocks are Undervalued or Overvalued

A lot of investors buy stocks without really knowing much about them. They might know that their performance has been good in the past (what I call looking in the rear-view mirror) and expect them to continue to do well going forward.

There’s only one problem: trees don’t grow to the sky.

Years ago Microsoft was a fast growing, small company. It’s stock doubled and doubled again, then again.

It just seemed to keep going up, no matter what.

One day, it became a very LARGE company.

There was no way it could keep doubling forever.

in 2000, it crashed, just like a lot of fast growing tech stocks.

Even 15 years later, it hasn’t exceeded the price it was in the year 2000!

Why am I telling you this?

Because the company you may want to buy requires more research than just buying it because it’s gone up in the past.

It would help to know if it’s overvalued or undervalued compared to the rest of the stock market wouldn’t it?

Of course it would.

There are many ways to check valuations, but today I’m going to show you the most basic method.

It’s called a “PE ratio”.

Now, before your eyes roll back in your head, let me tell you it’s an easy guide for you to use to determine whether a stock is overvalued or not.

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It’s a simple equation where you plug in the numbers.

P = Price per share, E = Earnings per share. Price divided by earnings. They will give you a number.

Again, the P/E Ratio is the price per share divided by the earnings per share.

Let’s say the price of Company A’s stock is $32 a share and the earnings are $2 a share.

Plug it in the formula. Price ($32) divided by earnings ($2) equals 16.

Now, to know whether or not 16 is a good number, you need to have an average to compare it to.

The long-term historical average P/E ratio of stock markets is 16.6. So compare that to company A’s 16 and it’s just slightly less than the market or slightly under-valued.

Now let’s look at some other helpful metrics.

The average P/E ratio for the Dow Jones Industrial Average over the last 12 months has been 17.3.

The average P/E ratio for the Nasdaq over the last 12 months has been 23.2.

The average P/E ratio for the Standard & Poors 500 largest companies over the last 12 months has been 23.1.

So company A is looking undervalued compared to these average P/E ratios because 16 is below 17 and 23.

Let’s look at some real life examples of some market leaders today: Apple, Facebook and Amazon.

Apple’s P/E ratio today is 12. Therefore, by this one, very basic metric it is actually looking undervalued because 12 is below the average of 17 for the Dow and 23 for the Standard & Poor’s 500.

Facebook has a P/E ratio today of 104. That’s far above our averages of 17 and 23 for the Dow & S & P, so by this metric, we could say it’s overvalued.

Amazon has a P/E ratio today of 954! Of course, that’s WAY above the average of 17 and 23 for the markets.

Does that mean you shouldn’t buy it? Not necessarily.

paying-billsOften high growth stocks look overvalued for long periods of time because people will pay more to own them.

Just realize, what you are saying when there is a high P/E ratio like this is, “I will pay $954 for $1 of earnings! Wow, that puts it in perspective how high this P/E ratio actually is! It’s definitely not undervalued!

Now, let’s talk about an advanced concept.

To really understand stock valuation, you need to understand there are only 2 ways to increase earnings. You can increase your sales revenues or decrease your expenses.

Let’s go back to our example with Company A.

Let’s say the price is still $32 a share, but the earnings have increased from $2 a share to $3 a share.

Pay attention, this is about to be really cool like a magic trick!

What’s the P/E ration now?

$32/$3 = 10.6

At 10.6, now the stock is very undervalued compared to the market averages.

Here we go, make sure you get this…

So, if our company A stock was going to have an average P/E ratio, how much would the price be?

X/$3 = 16

X = $48

So, if if earnings go from $2 to $3/share, then the stock price can jump to $48 and maintain the average market P/E ratio!


That’s called P/E multiple expansion.

I’ve just shown you how a stock can justify it’s price going up!

When earnings increase, the stock price can also increase to keep up with the average stock market P/E ratio.

If you got it, awesome! If I lost you with the math, don’t worry.

Just know that the more money a company makes and the more consistent it is, the more investors will want to buy the stock and the more the price will rise, making you very wealthy!

Now you know how to use P/E ratios to tell if a stock is overvalued or undervalued compared to the market.

You know that a P/E ratio is telling you how much you are paying for $1 of earnings.

You know that the average stock sells for about a 16 over the long-term, so most investors are comfortable paying about $16 for $1 of earnings.

When you have a P/E ratio much higher than the market, check other metrics to make sure you want to invest in this company.

Trees don’t grow to the sky and neither do stocks, so proceed with caution.

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