Overvalued? Undervalued?
Q: I’m new to investing. How can I tell when a stock is overvalued or undervalued? — D.L., Venice, Florida
A: A company’s intrinsic value is to some degree a subjective number. Smart, experienced analysts who study the same company and perform calculations with fancy spreadsheets are likely to come up with results that are somewhat or even very different because they’ll be based on different assumptions and estimates. Even great investors will often disagree on the fair value of a stock.
Still, there are ways to get at least a rough idea of how attractive a stock’s price is. You might, for example, compare its current price-to-earnings (P/E) ratio with its historical P/E range over the past five to 10 years.
PepsiCo, for example, was recently trading with a P/E near 30. A glance at its past ratios (available at Morningstar.com, among other sites) shows that its average P/E over the past five years is roughly 25. That suggests that PepsiCo’s stock may be overvalued right now. Of course, there’s much more to the picture. Potential investors should assess PepsiCo’s strengths, weaknesses and competitive advantages, along with its cash, debt, profit margins and growth rates, among other things.
There are other valuation measures to check out, too, such as price-tosales ratios.
The short story
Here’s a different way to make money in stocks: by shorting, which involves reversing the typical “buy-low, sell-high” order.
This is how it works: Let’s say that many investors have bought shares of Scruffy’s Chicken
Shack (ticker: BUKBUK), expecting great success. But you’re skeptical and expect the business to fail. You contact your brokerage and place an order to short Scruffy’s, a stock you don’t own. Your brokerage will borrow shares from a Scruffy’s shareholder and will sell them for you. (Yes, this is legal, and commonly done.)
Later, if the stock does fall in value, you’ll “cover” your short by buying shares on the open market at the now-lower price, to replace the ones that you borrowed. If you short Scruffy’s at $120 and cover when it hits $90, you’ll make $30 per share (less any commissions).
Shorting can be profitable if you correctly identify stocks that will fall. If the overall market tanks, your short positions will likely make you money, and even in a booming market, there will be companies in trouble that shrink in value.
But the risks in shorting are significant: If, instead of falling, Scruffy’s shares rose to $150, and you covered your short then, you’d have lost $30 per share (less any commissions).
And consider this: If you invest in a stock expecting it to rise and it falls to zero, you’ll lose 100% of your money — but no more. A shorted stock, though, could keep rising; it might double or triple in value. If you hang on through all that, your loss could be 200%, 300% or even more — the loss is theoretically unlimited.
Similarly, when shorting, your gain is capped at 100% (if the stock falls to zero), compared to unlimited possible gains when you buy a stock the usual way, hoping it will rise.
If you short a company, you’ll have its management working against you to make the company succeed. Shorting is best practiced by experienced investors, and even they can do well without it.