How To Tell If A Stock Is Overvalued?

• The best value stocks benefit from a good business and low valuation.
• If share prices have increased faster than earnings, it can signal a stock isn’t a value anymore.
• Similarly, if P/E ratios are above historical norms, like with this retailer, waiting for a better entry is wise.

A lot of attention is paid to buying stocks on sale, but figuring out what really is or isn’t on sale can be confusing. A stock may seem like a good buy because of business trends or catalysts, but those needle-moving things may already be priced into shares, leaving little room for additional upside. Similarly, stocks trading at a seemingly cheap valuation relative to the stock market may seem far less of a bargain when compared to peers or its past valuation.

When cheap isn’t necessarily cheap

Paul Price is Real Money Pro’s resident value expert. He continuously scours for stocks trading at bargain prices to mention to readers. For instance, I highlighted a well-known household name on his radar that’s a compelling buy on Friday.

This week, Price took a different approach. Rather than highlighting a stock on the discount rack, he explained why a popular stock you might think is a bargain isn’t cheap at all.

The best value stocks are inexpensive but also benefit from tailwinds likely to support sales and profit growth. Focus on the former and ignore the latter, and you could wind up owning stocks destined for dustbins rather than profit-friendly rebounds. Similarly, business tailwinds may propel stocks higher, but if shares are priced to perfection, it doesn’t leave much wiggle room if the business has a hiccup.

In the case of the “so-called” bargain stock Price highlights, it’s a matter of a strong business arguably being at risk of being too pricey. The company in question, Dollar General  (DG) , has a lot going for it, but the strength of its business hasn’t been overlooked.

“DG’s major business metrics could not be much better. It rates highly across the board. If the shares were more reasonably priced, they would be attractive to own.,” writes Price.

Consumer buying habits favor dollar stores because runaway inflation has outpaced wage growth since 2021. As a result, cost consciousness helped Dollar General’s revenue grow 18% year over year last quarter.

So, what makes Price think Dollar General isn’t reasonably priced? The company’s share price has risen faster over the past decade than its revenue and earnings.

And because share gains have outperformed earnings growth, the company’s price-to-earnings ratio, or P/E ratio, has become elevated.

Back to Price:

“Since 2013 an average P/E ran about 18.8-times… all nine of DG’s “best entry points” (green-starred below) saw rallies launch from below average P/Es…all three of Dollar General’s “should have sold” moments (red-starred) occurred when DG sold for elevated multiples. DG hit its highest valuation in recent history during April of 2022 when the shares touched $262.20 and fetched 24.6-times forward earnings.”

So, while Dollar General’s sales benefit from consumers downshifting spending and its roughly 20x P/E ratio doesn’t sound overly high, share prices have increased faster than business metrics over the past ten years, and it’s still expensive based on what investors have paid for each dollar of earnings historically.

“If DG simply returns to an average multiple of 18.8-times a 12-month target of $210.56 would be in effect even if EPS hit a new record of $11.20. Add an extra year to that equation and about $235 seems an appropriate target over the next 18 – 24-months. Buying DG at about $223 does not appear particularly promising.”

The Smart Play

There are two big takeaways from Price’s article. The first is that you ideally want to find companies where the increase in share price has lagged behind the growth in key metrics over the past decade, such as revenue and profit. The second is that you should make apples-to-apples comparisons regarding P/E ratios. The further a P/E ratio is below the historical average P/E ratio, the more likely you’ll find a stock that will benefit from reversion to the mean, rewarding you with greater returns.

Conversely, if a stock – like Dollar General – has seen its share price rise faster than its business performance or its P/E is above average, the stock runs a greater risk of being too expensive, subjecting it to downside mean reversion.