The stock market is considered to be unpredictable. People are always skeptical about investing in the stock market. However, it is essential for an investor to seek the necessary information about the stock market. This further can be beneficial in making informed decisions. To do so, initially, it is essential to know the difference between two important things, undervalued stocks as well as overvalued stocks. 

Undervalued stocks are considered to be trading below their intrinsic value. And the overvalued stocks are considered to be more highly priced than their true value. To understand them more and in detail, keep reading. 

Understanding undervalued stocks 

This term is used for shares or securities that have a lower market value than their real value. The stocks considered undervalued can be due to various reasons. It could be because of socio-economic, any kind of market slowdown, or it could be because of the sector-specific market. Most traders are always looking for undervalued stocks to invest in. By following this kind of investing, you are doing value investing. The strategy of investing in undervalued stocks was highly popular by Benjamin Graham and others. 

Understanding overvalued stocks 

The shares that have a higher market value than their real value are considered to be overvalued stocks. This is defined by various internal factors which are mainly controlled by a business. Also, the market prices are decided on external factors like market fluctuations, share demand changes and much more. The stocks of any company can also be overvalued depending on the situation where a company is going through a fiscal crisis or any fundamental changes. These are known to be internal factors.

How to identify undervalued stocks? 

Most people are unable to identify the undervalued stocks. There are major indicators as well as metrics that investors have to understand to choose the right stocks. This can also help in understanding the right points of market entry and exit. However, it requires intense research work on various factors such as company profits, revenues, and much more. 

The major indicators to identify undervalued stocks are: 

• Price-to-earning ratio 

When a company’s share prices are divided with its EPS, we can get a price-to-earning ratio.. This can be an effective metric for investors who are still new to the concept of undervalued shares. However, this is essential for value investors. A P/E ratio on the lower end is beneficial in understanding that the earnings per share of a business is high. To stabilize the share price, you can use this metric. Also, the opposite of it is a higher P/R ratio indicates that the stock price is high while EPS is stable. 

• Price-to-book ratio 

The calculation of the P/B ratio is done by dividing the stock price of every share by the book value of every share. This indicates the current financial condition of a business. Along with this, the potential of a firm can be understood for any future profits. Also, this ratio can be helpful in understanding any undervalued shares. However, if the book value of a stock is high compared to its market value then it signals that the stock is undervalued in the current market scenario.

• Net cash flow 

After the essential cash deductions, the cash which is left behind is known to be a company’s net cash flow. These cash deductions are dependent on capital expenditures as well as operating expenses. If a company is experiencing positive net cash flow then it is a positive sign that a company or business holds a complete potential to pay off any liabilities that exist. Plus, the company holds the potential to get done with paying out dividends, launching new products, and much more. 

Apart from the above-mentioned metrics that should be considered by a trader, there are many other qualitative factors that should be taken into consideration, such as: 

• The previous financial performance of a company. 
• A company’s legal as well as compliance history. 
• The nature of the products that a business offers. 
• Firm’s credit rating. 
• The financial performance of a company during its recession period. 

How to identify overvalued stocks? 

There are many traders and investors who wish to identify overvalued stocks with so much ease in the financial market. The metrics such as an annual report of a company, income statement, and many others can be effective. However, here are some points that can help identify overvalued stocks: 

• Price-to-earnings ratio 

This is known to be a ratio that is between the share price per unit of a business as well as received per-share earnings by every shareholder. Generally, it is the company’s share that is undervalued when the P/E ratio exceeds 50. Overall, it is effective for investors to understand the share prices and whether it is higher than the ability to cover all the dividends. 

• PEG ratio 

For better overvaluation understanding, the P/E ratio is effective. However, the assessment scope has minimum depth involved in it. However, the gap can be filled by the PEG ratio. The one year’s EPS growth rate can be projected with the help of PEG ratio.. After this, the subtraction of payable tax is done. Thus, you will get an accurate PEG ratio.

If the PEG ratio value turns out to be above 2 then it indicates that there is stock overvaluation. And if there is low PEG value then you need to consider the stock undervalued. However, the vice-versa is also considered true.

• The percentage of dividend yield relative 

To measure the performance of a business, this metric can be used. It considers the dividends that a company pays and later compares the latest dividend payout with the previous data. Overvalued shares can be understood easily because the companies mostly pay lower dividends as compared to the past payouts. This offers a clear understanding of the financial capacity of a firm and its long-term potential. The analysis can be beneficial for beginners in the financial market because the complex data analysis is missing and assessment of only historical dividend payouts is done.

• Understanding cyclical fluctuations 

Cyclical fluctuations analysis should be considered by every investor and trader. There is no guarantee of how these fluctuations can affect the stocks. This can be explained by an example, if there is an undergoing expansion in the economy, some sectors could benefit from it in comparison to others. Thus, it can benefit the investors directly. Also, a value trap is a great phenomenon where shares are bought by investors that are rising due to economic expansion. However, they regretted it later due to the quick fall of the market. 

Conclusion 

Understanding the ins and outs of overvalued as well as undervalued stocks is mandatory for every investor. This can be beneficial in maximizing the returns and minimizing the risks. Also understanding essential financial indicators and the dynamics of the stock market, investors can make an informed decision. However, if you are a beginner and everything seems confusing then joining an online stock market course with The Profits Manager Institute can be beneficial. We provide insights into the stock market and the ways to be a proficient investor in the long run.