Investing in the stock market is centered around value. The ultimate goal is to buy an undervalued stock at a low price and sell it when the price of the stock climbs, generating a profit.
However, the stock market is a battlefield. War is waged each day between the bears (those who believe the values of stocks will fall) and the bulls (those who believe the values of stocks will rise). When the bulls lead the charge, prices will rise. Conversely, if the bears are in the lead, declines are the result.
Because of this ongoing tug-of-war, prices in the stock market are far from stable. Constant movements up and down as the war between bears and bulls rages on mean that the price of a stock today will likely be different from what you will pay for that stock tomorrow.
This has given way to several strategies, both short- and long-term, that are designed to help investors buy when valuations are low and sell when valuations are high, ultimately leading to large profits.
But what are stock market valuations? How do you know whether the current price of a stock is high or low? And how can paying attention to valuations make you a better investor?
What Are Stock Market Valuations?
The term “valuation” is rather loosely used. In fact, there are two widely accepted meanings of what stock market valuations are:
The Current Price of a Stock
When watching, listening to, or reading financial media, you may come across someone saying “stock valuations have never been this high” or “at valuations this low, it’s hard to ignore these opportunities.”
When the term is used in these ways, it points to the current prices of stocks or prices within overall sectors or across the overall market:
When current valuations are high, it means that the price you pay when entering the investment is high in comparison to the underlying assets offered up through the investment.
For example, ABC stock generally trades at 10 times earnings. After a string of press releases, excited investors pushed the value of the stock to 15 times earnings. At this point, the value of the stock is high compared to historical values, suggesting that it may be overvalued and declines could be ahead.
Low valuations live on the opposite side of the spectrum. This is when stocks trade at a discount relative to the underlying assets they represent.
For example, perhaps a lack of blockbuster news from ABC stock has led to a loss of interest among the investing community. As a result, ABC is now trading at seven times earnings, suggesting that the stock is heavily undervalued and that gains are ahead.
The Underlying Value of a Stock
While the term valuation is often used to describe the price as a stock currently sits relative to its underlying assets, stock valuations are often used to describe the underlying value of the assets represented by a stock.
The underlying value of assets represented by a stock is known as intrinsic value or fair value, which often differs wildly from the stock’s current market price.
The underlying value of a stock takes several fundamental factors into account. For example, when determining the intrinsic value of a stock, an investor will use a series of ratios, taking factors like revenue, earnings, and book values into account.
For example, many use price-to-earnings (P/E) as a key valuation ratio. This ratio compares the current price per share to the earnings generated by the company represented by a stock.
For example, ABC stock recently reported $1.00 per share in earnings. The current price of the stock is $10.00 per share. At this rate, the price-to-earnings ratio is 10, suggesting that investors pay 10 times earnings to own shares in the company.
This calculation can be reversed to help you divine a fair price to pay for a stock based on its intrinsic value.
Let’s say that XYZ stock is in the tech industry, which has an average price-to-earnings ratio of 22.3. You know the company generated $0.50 per share in earnings.
Multiplying earnings by the average industry price-to-earnings ratio ($0.50 x 22.3) tells you that XYZ stock should trade at about $11.15 per share
If the stock price is currently trading at $8.30 per share, the calculation shows you that, in terms of price-to-earnings based valuation, XYZ stock is heavily undervalued compared to its peers.
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How Stock Market Valuations Are Determined
Current stock market valuations are determined by the investing community. When demand is high, valuations rise. Conversely, if demand is low, valuations decline.
However, when diving into the intrinsic value of a company to determine whether the current value is high or low, the answer is far less clear.
While valuation experts would like for you to believe calculating intrinsic value is an exact science, it’s far from it. Exact sciences give you a path that will always lead to the same conclusion. However, different investors value stocks in different ways, making valuation more of an art than a science.
Nonetheless, when determining the intrinsic value of a stock, investors and valuation experts will look into key fundamental data surrounding the stock.
In most cases, the fundamental data investors consider includes the following ratios:
The price-to-earnings ratio compares the current price of the stock to the earnings per share. A stock that generates $0.50 per share in earnings and trades at $10 per share trades has a price-to-earnings ratio of 20.
The price-to-book-value ratio compares the current price of the stock to the book value of the underlying assets held by the stock.
For example, if ABC stock trades with a market capitalization of $50 million and its assets have a book value of $25 million, the price-to-book-value ratio for the stock would come in at two, meaning that you would pay twice the value of the underlying assets in exchange for an ownership position in the company.
Finally, the price-to-sales ratio compares the current price of a stock to the sales generated by the underlying company throughout the previous year.
For example, a company with annual sales of $200 million and a market cap of $2 billion trades with a price-to-sales ratio of 10, meaning that you pay 10 times average annual sales for an ownership position in the company.
Once the above metrics are calculated, investors compare them to benchmark averages to determine if the stock they’re interested in is undervalued, overvalued, or trading on par with its fair or intrinsic value.
This is where valuation falls out of the category of exact science and becomes more subjective. There are several different benchmarks to consider, and opinions regarding which benchmarks are most important vary wildly.
Some of the most commonly used benchmarks include:
Overall Market Valuations
Some investors compare the current valuation ratios of a stock to those of the entire market, using valuation metrics from indexes like the S&P 500, Nasdaq Composite Index, or Dow Jones Industrial Average.
To get a more in-depth look at fair market valuations, some investors prefer to compare valuation metrics associated with a specific stock to valuations across the industry in which the stock operates.
For example, Apple investors would compare the company’s price-to-earnings ratio to price-to-earnings ratios across the rest of the tech sector.
Don’t worry, you don’t have to do the math on hundreds of stocks to figure this out. Simply type “technology sector price-to-earnings ratio” into Google and you will be led to several free resources that have already done the number crunching.
Comparable Stock Valuations
Although this is the most work-intensive option, many experts argue that comparing stock valuations with valuations of comparable stocks is the most accurate way to determine if a specific stock is undervalued.
For example, let’s say ABC company is focused on the development of education-related technologies. Instead of comparing ABC’s metrics to tech as a whole, you could look into other stocks with comparable market caps, products, and annual sales.
From there, you can average valuation metrics across this closely comparable list of stocks to determine if the stock you’re interested in is under- or overvalued.
Sure, finding closely comparable stocks and averaging valuation metrics across them is research-intensive. But in terms of the accuracy of valuation calculations, there’s no better way to go.
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Why It’s Important to Pay Attention to Stock Market Valuations
Paying attention to stock market valuations before making investment decisions is akin to looking at the price tag on any other product you’re purchasing.
Think about it in terms of buying a familiar gallon of milk. If you go to a store and find that they charge $2 more for a gallon of milk than anywhere else, you’re not likely to buy your milk there.
No matter what the product — be it an investment vehicle or a gallon of milk — nobody likes spending more than they have to.
When it comes to investing, paying more than you should isn’t just a painful mistake, it can ultimately lead to significant losses and devastate your opportunity to generate meaningful compound gains.
Although market valuations are known to vary wildly, they tend to stay between two key technical points:
- Support. Support is the point at which a falling stock rebounds and starts to head upward. The idea is that the stock’s valuation is so low at support that it’s unlikely for it to fall any further. In general, the goal is to buy at or near support, when a stock is most heavily undervalued.
- Resistance. Resistance is the opposite of support, or the point at which a rising stock reverses directions and starts heading down. Stocks at or near resistance are generally trading at overvaluations when compared to their peers. As a result, many investors make the decision to sell at resistance.
As the battle of the bears and bulls wages on, level heads eventually prevail. When valuations become too low, investors jump in, leading to an upward correction and bringing the value of the stock closer to a fair market value.
On the other hand, when valuations climb to out-of-control highs, investors sell, leading to a downward correction and bringing the stock closer to its fair, or intrinsic, value.
Without paying attention to valuations, the chances of you buying near support or resistance are more of a crapshoot than a calculated risk. So, by ignoring valuations, you’re gambling rather than investing.
Are Overvalued Stocks Always Going to Lose?
Most investors compare current valuations of stocks to the valuations across the rest of their sector, staying clear of anything that’s overvalued compared to its industry.
But does the fact that a stock is overvalued compared to its peers automatically mean that the stock is a bad investment?
Well, not exactly.
Buying stocks that are overvalued in comparison to their entire industry is a risky move, no matter what stock you’re buying. However, there are some circumstances where overvaluations can be justified, and investments in these stocks can lead to dramatic long-run gains.
Some of the most common of these instances include:
The old adage “it costs money to make money” reigns as true today as it did years ago. Oftentimes, companies spend massive amounts of money in an attempt to build infrastructure that will give them a competitive advantage.
This can cut deep holes into profitability.
As such, in these cases, when comparing price-to-earnings ratios among the stocks of big spenders to other companies across the sectors in which they live, valuations may seem to be incredibly high.
However, the competitive advantages offered by the infrastructure improvements create long-term value in and of themselves.
For example, Amazon.com operated at a loss for several years. At the same time, the company spent hundreds of millions of dollars to build fulfillment centers across the United States.
Many argued that Jeff Bezos, the company’s CEO, was on a spending spree that would run Amazon.com into the dirt. At the time, overvaluation was an understatement: the stock was trading at just under $100 per share despite losing money for years.
Those investments paid off.
Due to its large investments in infrastructure, Amazon.com provided consumers with a convenient way to shop online and best-in-class shipping times. It quickly became the goliath of the e-commerce industry, today trading at thousands of dollars per share.
Companies that focus on cutting-edge technologies within their sector are often overvalued as well. However, the idea is that these technologies will be in such high demand that the overvaluation is justified by potential future profitability.
It’s this type of justification that led to the dot-com bubble. In the late 1990s and early 2000s, widespread adoption of the World Wide Web led to tremendous overvaluations of companies associated with anything online.
Although the vast majority of these overvaluations were the furthest thing from justified, this was also the era in which companies like Amazon.com and Alphabet (previously Google) gained their footing.
While both of these stocks experienced tremendous overvaluations when compared to the tech sector as a whole, their cutting-edge technologies proved to be enough to justify these overvaluations, leading to continued gains for years ahead.
Major Medical Breakthroughs
Medicine is one of the biggest industries in the world. Grand View Research suggests that personalized medicine will grow to become a $3.18 trillion dollar industry by the year 2025.
While there are more effective therapeutic options today than ever before, there are still devastating illnesses that result in tremendous suffering and loss of life around the globe. Companies that make major breakthroughs in the treatment of these illnesses often experience overvaluations.
For example, several companies are working to develop vaccines and treatments to fight against the COVID-19 pandemic. The vast majority of companies in the race to develop vaccines and treatments are heavily overvalued when compared to the biotechnology and health care sector as a whole.
There’s a good reason for the overvaluation.
COVID-19 is a global pandemic that has changed the lives of consumers. While Americans are venturing out into public again, it’s likely been a while since you’ve seen a stranger’s smile, as mouths and noses remain concealed by face masks.
When an effective vaccine becomes available, sales are guaranteed. Countries around the world are bidding on hundreds of millions of doses of not-yet-approved vaccines in an attempt to protect their citizens.
As a result, as soon as a vaccine is approved, it will fly off of the shelves, making some current overvaluations seem like undervaluations.
While many companies in the COVID-19 bubble will fizzle, some major players are likely to retain — or even grow — their value ahead.
Always Consider the Risks
Although some overvaluations are justified by infrastructure spending, cutting-edge technologies, and medical innovations, making an investment in a stock that’s overvalued compared to its peers always comes with a high level of risk.
In many cases, overvaluations across industries are signs of bubbles. As seen at the end of the dot-com and real-estate bubbles, the vast majority of overvalued companies caught in the midst of a bubble will experience significant losses.
Sure, there are strong opportunities in these situations — as Amazon.com and Google were in the midst of the dot-com bubble — but finding these opportunities is like finding a needle in a haystack.
So, if you’re chasing what you believe will be a game-changing technology or medicine, make sure to only invest what you are prepared to lose.
Stock market valuations are one of the most important aspects to consider when making an investment.
In fact, many investors center their portfolios around valuations with strategies like value investing, which focuses on identifying and buying underpriced companies.
Ultimately, by digging into the valuations of the stocks you’re interested in, you can time your entrances around discounts.
Knowing that the market will generally correct over- and undervaluations, if you find that a stock you’re interested in is overvalued, waiting a few weeks or months to enter at a point of undervaluation will shield your portfolio from losses while offering you a discounted opportunity to get in on future gains.
Experts agree that research is an important aspect of investing. While beginners generally see this as research into the products the company offers and the long-term opportunities provided by these products, research into a company’s current and intrinsic values is equally important.