How Do You Know If a Stock Is Overvalued?

“Is this stock overvalued?” is really two questions hiding in one: what am I paying, and what am I getting for it. No single number answers both — but a few simple comparisons get you most of the way.

The short answer

Compare the price with what the business earns, then compare that with the company's own past and with similar companies. If you're paying much more than usual for each dollar of profit or cash, the price is assuming a lot of good news. That isn't proof it's overvalued — but it's the question to ask.

Price compared with profit: the P/E ratio

The P/E ratio tells you how many dollars investors pay for each $1 of the company's yearly profit. A P/E of 20 means about $20 for every $1 earned in a year.

Profit can be bumpy, though, and accounting can move it around. So it helps to check a second measure.

Price compared with cash: P/FCF

Price to free cash flow works the same way, using the spare cash the business actually produced instead of accounting profit. When the two tell a similar story, you can be more confident in it. When they disagree, it's worth finding out why — see What Is Free Cash Flow?

Compare a company with its own history

A P/E of 30 is high for a supermarket chain and ordinary for a fast-growing software company, so comparing across very different businesses can mislead. A fairer first comparison is the company with itself: is today's price lower than usual, around usual, or higher than usual compared with its own past five years?

If it's well above its usual range, ask what has changed. Maybe the business really has improved. Or maybe expectations have simply run ahead of results.

What these measures can't tell you

• The future. A high price can be justified if growth arrives. A low price can be a warning sign rather than a bargain.
• Losses. A company that doesn't make a profit has no meaningful P/E at all — you'll need to look at sales and cash instead.
• The quality of the business. That's a separate question — see Why Can a Great Company Be a Bad Investment?

“Overvalued” isn't a fact you look up. It's a judgement about whether the price already assumes more than the business is likely to deliver.