The idea behind investing in undervalued stock is that the price of this stock is more likely to rise over time because it is being sold for less than its worth. On the other hand, most investors like to avoid overvalued stock, which is selling for more than its intrinsic worth.
An overvalued stock has a current price that is not justified by its earnings outlook, known as profit projections, or its price-earnings (P/E) ratio. Consequently, analysts and other economic experts expect the price to drop eventually.
Overvaluation may result from an uptick in emotional trading, or illogical, gut-driven decision-making, that artificially inflates the stock’s market price, or from deterioration in a company’s fundamentals and financial strength. Potential investors strive to avoid overpaying for stocks.
Relative earnings analysis is the most common way to identify an overvalued stock. This metric compares earnings to some comparable market value, such as price. The most popular comparison is the P/E ratio, which analyzes a company’s earnings to its stock price.