What it means
Every investment has a price, which is what buyers will pay today, and a value, which is what the asset is really worth based on the cash it is expected to generate. When price is above value, the asset is overvalued, and the buyer is paying for more growth or safety than is likely.
Eventually, prices tend to drift towards value, though it can take years. Analysts use several methods to estimate value.
A discounted cash flow model adds up expected future cash and adjusts for the time value of money (the idea that money today is worth more than money later). Others compare ratios such as price to earnings with similar companies or with the share's own history.
Overvaluation can come from excessive optimism, easy money, fashionable themes or a shortage of alternatives. Bubbles are extreme cases in which prices rise far above any reasonable value because buyers expect to sell to someone else at a higher price.
They end when confidence breaks. For business owners and finance teams, the concept matters when buying a company, issuing shares or setting the price of a deal.
Paying too much creates a loss of value for the buyer that no later efficiency can easily recover. Issuing shares when they are overvalued can be a cheap source of funding for the company.
The nuance is that value rests on assumptions. A small change in the growth rate or the discount rate can move the estimate by a large amount, so it is wise to test a range of outcomes instead of relying on one number.
Relative valuation can mislead when a whole market is expensive. A share that looks cheap against its peers may still be overvalued against its own cash flows, so it helps to use both methods.
In practice
Real-world examples.
Example
A growth company trades at 80 times earnings while similar businesses trade at 25 times. An analyst argues that even strong growth cannot justify the gap. She recommends that clients do not buy more shares.
Example
A private equity firm is offered a manufacturer for $120,000,000. Its model says the business is worth $95,000,000 on realistic cash flows. The firm declines, judging the asking price to be overvalued by about 26%.
Example
A homeowner sees houses in her street selling for $600,000 when rents suggest values nearer $450,000. She decides to keep renting. The price gap is a signal that the property market may be overheated.
Formula
Calculation
Overvaluation percentage = (market price - intrinsic value) / intrinsic value
A share trades at $75. An analyst's discounted cash flow model estimates intrinsic value (the underlying worth) at $50. Overvaluation = (75 - 50) / 50 = 25 / 50 = 0.50, or 50%. The market price is half as high again as the estimated value.
Reading the result: if the share price fell to $50, a holder would lose 25 / 75 = 33.3% of the current market value. If the analyst's assumptions were too cautious and the true value is $70, the share is only (75 - 70) / 70 = 7.1% overvalued, which shows how sensitive the conclusion is to the inputs.
A quick cross-check uses the price to earnings ratio. If the share earns $2.50 per share, then $75 is 75 / 2.50 = 30 times earnings, while $50 would be 20 times, so the analyst is saying that 30 times is too much to pay for this business.Case study
Seen in the real world.
Marigold Cloud is an illustrative, fictional software company whose shares rose from $20 to $90 in a year after a successful product launch. Its profits were growing by about 20% a year, but the price implied growth of more than twice that.
The chief financial officer used the high price to issue new shares and raised $60,000,000, which she kept as cash. Two years later, growth slowed and the share price fell to $35, but the company had the cash to continue its plans.
An investor who bought at $90 in the same illustrative story lost 61%, calculated as (90 - 35) / 90. The lesson is that a good company can still be a poor investment at too high a price.
Watch out
Common mistakes.
- Assuming that a high price proves the market is right, when prices can stay above value for long periods.
- Calling a share overvalued from one ratio alone, without checking growth, risk and comparable companies.
- Believing an overvalued share must fall immediately, when timing is very hard to predict.
Questions
People also ask.
How do you know if something is overvalued?
You compare the market price with an estimate of intrinsic value, using methods such as discounted cash flow or peer multiples.
Is overvalued the same as expensive?
Not quite, as an expensive asset may still be worth its price if its growth and quality justify it.
Who benefits from overvaluation?
Sellers and issuers, who receive a high price, while buyers who pay it carry the risk of a later fall.
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