You will hear the word ‘overvalued’ very often in the stock market.
“The market is overvalued”
“Bajaj Finance is overvalued”
“XYZ stock is overvalued”
What does ‘overvalued’ really mean? Should investors avoid overvalued stocks?
When ‘experts’ on news channels say the ‘market is overvalued’ should investors sell their shares and stay out of the market?
Overvalued means the current share price is higher than its intrinsic value or its real worth. In simpler words, overvalued simply means the share price is too high.
To help understand this better, let us take a different example.
Apple releases a new iPhone and the price, like with all Apple products, is high. What would you say? The iPhone is over-priced or too expensive.
However, what would you consider to be the ‘fair value’ of the iPhone? The answer would vary from person to person.
Those who like Apple’s ecosystem, the build-quality of their products – will say the price is worth it. Others would be willing to buy if the price were 10-20% lower. Some would probably only consider buying an iPhone if the price was 50% lower.
The same applies to the stock market too.
Quality companies will always be overvalued
High quality companies with growth potential and predictable earnings, will quote a high price. If the company is a leader in its segment, like Asian Paints for example, the company would always command a higher premium.
It is hard to buy a quality company at a cheap price.
Let us take another example.
Bajaj Finance has always been an overvalued company in the last 10 plus years. The average price to earnings (PE) of Bajaj Finance over the last 5 years is 50.
The PE has fallen below 30 only once in the last 5 years, that was during the stock market crash last year (2020).
This was the time when most analysts believed the stock price would go to 3 digits (below 1000) and all lenders would be in trouble for many years.
It’s difficult to buy even the best of companies during a market crash – simply because there is too much negativity and fear.
Even for experienced investors, it is difficult. This is because quality companies will be available for cheap only during a market crash.
If an investor has guts to buy during crashes, he will find other cheaper opportunities. If Bajaj Finance or HDFC Bank crash by 40%, you will find lower quality banks and NBFCs have crashed 60-70% in the same market crash.
In other words, even in a bear market – quality stocks would appear to be ‘overvalued’ or ‘expensively – when compared to other stocks.
Do not avoid companies that seem overvalued
One of the biggest mistakes an investor can do is to avoid companies that seem to be overvalued.
You will often find, expensive remains expensive or becomes more expensive.
There has never been a wrong time to buy Bajaj Finance in the last 10 years. Never.
You would have made money irrespective of when you bought Bajaj Finance. The same applies to HDFC Bank, Asian Paints etc.
What should be analyzed is the potential for future growth. In a country like India, even the top companies have a long way to go. Very few people have Air conditioners at their homes.
A significant section of the population has only seen electricity, gas and a home to live for the first time in the last 5 years. If you find a ‘overvalued’ company which sells air conditioners, it may not really be overvalued.
Avoid selling an overvalued company
One of the biggest mistakes inexperienced investors do is to sell a high-quality company too early – thinking it is overvalued.
Believe me when I say, in most cases, such companies will not give a chance for re-entry once you sell them.
It is okay to sell a part of your holding if the allocation percentage in your portfolio has gone too high. It is also okay to sell entirely if you find a much better opportunity.
But never sell just because ‘you think’ the price has gone too high. Do not make the mistake of thinking “the share price cannot rise any further, it has already gone up too much”
The market ALWAYS ends up showing how high it can rise. And the same applies on the downside too. If you think a share has already fallen too much, “it cannot possibly fall more from here” the market will once again show how low it can go.
A share that has fallen 90%, can fall 90% more. A share which has risen 100%, can rise 1000% more. It is possible and it has happened.
Do a comparison between Yes Bank and Bajaj Finance and you will get your answer.
The article was probably a little longer than it was meant to be, but hope it was worth your time. Feel free to post your views in the comments section below.
Disclaimer: We do not give stock recommendations on this website. Stock names mentioned above are for the sake of providing an example.