How to identify over-valued/under-valued shares?

Answer 1

The two most common measures are book value and price to earnings ratio. It is indeed more complicated, but these are two consistent benchmarks. Book value is essentially determining the stockholder equity, per share, and comparing that to the price. If the bookvalue is less than one, then a stock may be suspected for being undervalued--suspected.

The other is the PE, or price to earnings ratio. Once more, the earnings per share is compared to the price per share. If a stock is upwards of 20 or 25 times earnings, to me that is overvalued--to me.

The reason folks are paying so much can be because they see others paying so much. It becomes a game of chicken, the last one buying at the high price before everyone else starts dumping the stock to get out--loses. The legitimate reason is because the stock may have suffered some bad times, but good times are coming--which could be a new product or even a change in weather.

Then there are the undervalued shares. They could be cheap because they are ignored by all those throwing money at the current stock they are playing "chicken" with, often on the most actively traded list. Boring stocks tend to be ignored and ignored stocks tend to be cheap. On the other hand, undervalued stocks, particularly by these two bench marks might simply be a flag that others know that business is not good, so they are staying away. There could be too much debt. There could be too many competitors. It could be that their product is horribly obsolete. It could be that the management is more interested in the golf course than the course of business. If business is not good, I wouldn't pay much for them either, would you?

Answer 2

It is not an easy task. That is why many traders are use technical analysis. They quite frankly could care less whether an investment is over/under valued. They base their actions on what the performance of the investment indicates based on the chart pattern.

My rule of thumb is if the pe is above 20 there is a very good chance the investment might be overvalued. It may not be but chances are that it is. If the pe is about 25 it definitely overvalued except in certain unique cases.

If the pe is below 15, an investment might be undervalued. It is worth investigating further perhaps. The key is whether its peg ratio is less than 1.0. If so it is certainly worth investigating further. Check out the oil companies. COP DVN etc.

Answer 3

Compare metrics of valuation such as market cap, P/E ratio, Price/Sales, Price/Book, PEG ratio to other similar companies in the same sector.