An investment that trades for more than its intrinsic value
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What Does Overvalued Mean?
An overvalued asset is an investment that trades for more than its intrinsic value. For example, if a company with an intrinsic value of $7 per share trades at a market value $13 per share, it is considered overvalued.
Intrinsic Value
An investment is either undervalued or overvalued compared to its intrinsic value. Because an investment’s intrinsic value is subjective, so is its “over/under” valued label.
As a refresher, the intrinsic value of an investment is the price a rational investor would pay for the investment. The concept is most commonly represented by the Net Present Value (NPV) of all future cash flows the investment will produce. For a recap on the subject, please see CFI’s valuation methods guide, as well as the financial modeling guide, and types of financial models.
Undervalued vs. Overvalued
If the value of an investment (i.e., a stock) trades exactly at its intrinsic value, then it’s considered fairly valued (within a reasonable margin). However, when an asset trades away from that value, it is then considered undervalued or overvalued.
Value vs. Growth Investing
Investors who subscribe to the concept of value investing will not purchase stocks that are above their intrinsic value. Instead, they only look for opportunities to find “cheap” stocks. The opposite of a value investor is a growth investor, which is someone who believes that the stock is, in fact, not too expensive and will deliver more growth then the market (i.e., other investors) expect.
Short vs. Long Strategies
When a stock is overvalued, it presents an opportunity to go “short” by selling its shares. When a stock is undervalued, it presents an opportunity to go “long” by buying its shares. Hedge funds and accredited investors sometimes use a combination of short and long positions to play under/overvalued stocks. To learn more about trading, check out CFI’s technical analysis guide.
Ratios for Overvalued Investments
There are many tools investors can use to discover assets (usually stocks) that are worth less than the price they have to pay for them. Here are some examples of commonly used ratios for assessing whether a stock is undervalued or not:
Price vs. Net Present Value (P/NPV)
Price-to-NPV is the most complete method for valuing an investment. To perform P/NPV analysis, a financial analyst will create a financial model in Excel to forecast the business’ revenues, expenses, capital investments, and resulting cash flow into the future to determine the Net Present Value (NPV).
Next, the financial analyst will compare the resulting value from the Discounted Cash Flow (DCF) analysis to the market value of the asset. Check out CFI’s free financial modeling guide to learn more.
More Valuation Ratios
If a financial analyst doesn’t have enough time or information to create a financial model from scratch, they may use other ratios to value the company, such as:
- Enterprise Value to Revenue
- Enterprise Value to EBITDA
- Price to Earnings
- Price to Book Value
- Price to Cash Flow
- Dividend Yield and/or Dividend Payout Ratio
When using the financial ratios above, it’s important to avoid falling into the “overvalued trap.” Since companies can regularly have fluctuations in their financial statements, the ratios may appear more unfavorable then they should be over the long term.
A company can often incur one-off expenses on their Profit and Loss (P&L) Statement or include an asset write-down on their Balance Sheet when such accounting practices don’t automatically represent the long-term expected performance of the company.
Additional Resources
Thank you for reading CFI’s guide on Overvalued. To keep learning and advancing your career, the following resources will be helpful:
FAQs
1. : to assign an excessive value to. overvalue a stock. 2. : to value too highly : place too much importance on.
What is an example of overvalued? ›
An overvalued asset is an investment that trades for more than its intrinsic value. For example, if a company with an intrinsic value of $7 per share trades at a market value $13 per share, it is considered overvalued.
Is overvalued good or bad? ›
Overvalued stocks are ideal for investors looking to short a position. This entails selling shares to capitalize on an anticipated price declines.
What does overvalued mean in revaluation? ›
On the other hand, overvaluation means that an asset or a liability is shown at a higher value than its actual value. The given below is the treatment of undervaluation and overvaluation of assets or liabilities in the Revaluation Account.
What is a synonym for overvalued? ›
synonyms: overappraisal, overestimate, overestimation.
Is undervalued or overvalued better? ›
Generally, undervalued shares are favored over overvalued ones, as the investors buy low and sell high. If the company is performing well, it can give promising returns. Buying an overvalued share doesn't have this advantage, as the price returns to its intrinsic value, which is lower.
What is an overvalued belief? ›
Abstract. An extreme overvalued belief is shared by others in a person's cultural, religious, or subcultural group. The belief is often relished, amplified, and defended by the possessor of the belief and should be differentiated from a delusion or obsession.
What does "undervalued" mean? ›
to consider something to have less worth or importance than it really has: The enormous stock of gold has been deliberately undervalued at about one-quarter of the market price. I think perhaps we've undervalued your talent.
What is an example of undervalued? ›
An undervalued stock is defined as a stock that is selling at a price significantly below what is assumed to be its intrinsic value. For example, if a stock is selling for $50, but it is worth $100 based on predictable future cash flows, then it is an undervalued stock.
Is undervalued a good thing? ›
One key benefit of investing in undervalued stocks is the potential for high returns. You may see substantial capital appreciation when the market eventually corrects and prices align with the stock's intrinsic value. Undervalued stocks often come with a margin of safety, reducing the downside risk for investors.
Advantages of Undervalued Stock
It presents an opportunity to purchase shares at low prices from well-established or promising companies. These stocks also feature low risk due to the fact that such undervaluation is cyclical and the company has the potential to attain its intrinsic value.
Is overvalued a profit or loss? ›
When the closing stock is overvalued, it results in an increase in the cost of goods sold and a decrease in the gross profit. This, in turn, leads to a decrease in the profit of a business.
Does overvalued mean appreciation or depreciation? ›
Appreciation is the rise in the value of an asset, such as currency or real estate. It's the opposite of depreciation, which reduces the value of an asset over its useful life. Increases in value can be attributed to interest rate changes, supply and demand changes, or various other reasons.
What happens when assets are overvalued? ›
Overvalued assets can be a concern for investors, as they may be at risk of losing money if the asset's price falls to its true intrinsic value. In some cases, overvalued assets can also be a sign of a broader market bubble, which can lead to a market correction or crash.
Does undervalued mean overpriced? ›
An undervalued stock is believed to be priced too low based on current indicators, such as those used in a valuation model. Should a particular company's stock be valued well below the industry average, it may be considered undervalued.
Why is it bad if a stock is overvalued? ›
If investors purchase overvalued stocks at inflated prices, they will likely experience significant losses when the price eventually corrects its intrinsic value. This can cause long-term damage to an investor's portfolio and retirement savings.
What is an example of an overvalued asset? ›
Overvalued Asset Definition
Put another way, it's an asset whose current price is not matched by its earnings outlook (profit projections). This is easy to understand in action. If a stock's intrinsic value is $10 and it's currently trading for $20, that stock is overvalued.
Why is it bad for a company to be overvalued? ›
Overvalued startups can be a tricky business, and it's not just the company that's at risk. The pressure to perform can lead to burnout and stress for employees, and if the company fails to meet expectations, it can result in significant financial losses.
