Warning: These 5 Stocks Are Overvalued
An overvalued stock isn't automatically a bad company. All five companies in today's overview have a real competitive advantage and some of them are among the highest-quality businesses on the US market. Yet their price has run ahead of what they are able to earn in the foreseeable future. We looked at exactly where the discrepancy between valuation and fundamentals arises and why for half of these names common metrics are so misleading that they cannot be used for decision-making.
Key points
An overvalued stock doesn't have to be a bad company. With these five, the problem is precisely how much optimism the current price already contains.
Five stocks, but several different forms of overvaluation. So for each one we need to look for the problem in a completely different place.
Common valuation indicators can send an investor in the wrong direction. For part of the selection, the numbers on the screener don't say what they seem to at first glance.
Even a great business doesn't have to be a great investment at any price. With some names, today the market leaves surprisingly little room for error.
What if companies meet expectations and the stock still doesn't earn anything? That is one of the biggest risks that high valuations bring.
Why the topic of valuation is important right now
The S&P 500's forward P/E is around 20 times expected earnings, above the five-year average of 19.9 and the ten-year average of 19.0. The index itself isn't cheap, but it isn't extremely expensive either. More interesting is the dispersion within the market. For some companies, valuations have become so detached that they would need to deliver several years of flawless execution just to catch up to their valuation.
The key tool is forward P/E, the ratio of price to earnings expected over the next twelve months. Comparison with trailing P/E, which works with reported numbers, often reveals that there is something in the accounting that won't repeat. If forward P/E is significantly higher than trailing, the market is counting on a decline in earnings. That's exactly the case for two of today's names.
Overvaluation isn't a state or a sell signal. For some of the companies below, it's a premium for quality that the market pays consciously. For others, it's an optical illusion created by accounting. Each of these situations requires a different reaction. What companies are they?