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A chart showing a stock going literally off the chartWhen market volatility sets in, the savvy investor looks for opportunities. If stocks are overvalued, employing a shorting strategy could help you reap gains in your portfolio, but it’s not without its risk. Short-selling involves borrowing stocks, selling them at their current price, then repurchasing them later at a lower price so you can return them to the investment firm you borrowed from. If the price drops, you see a profit. This tactic can be profitable if you’re able to identify the right stocks at the right time. Knowing how to recognize an overvalued stock is essential if you’re considering a shorting strategy to capitalize on market trends.

Overvalued Stock, Definition

First, it’s important to understand what it means for a stock to be overvalued. Generally, a stock is considered to be overvalued when its price isn’t justified by its earnings outlook. In other words, the stock trades at a price that’s above its fair market or intrinsic value. So if a stock’s intrinsic value is $10 per share but it trades at $20 per share, it would fit the definition of being overvalued.

There are different reasons why a stock may become overvalued. For example, the stock’s price may hold steady or increase even as the company’s underlying fundamentals taper off. When investor confidence is on the rise, pushing up demand for a particular company’s products or services, that can also result in an overvalued stock. And a stock could also be considered overvalued if prices continue to rise, despite earnings falling short of predicted growth estimates.

An overvalued stock is the opposite of an undervalued stock. When a stock is undervalued, it trades at a share price that’s below what the stock is actually worth. This type of stock is typically most appealing to value investors who rely on a buy-and-hold strategy.

Shorting Overvalued Stock in a Volatile Market

The premise behind shorting a stock is that you can capitalize on downward trends. So if you come across a stock that’s overvalued and short it, you could theoretically make money once the price begins to drop.

Short-selling can be risky because you’re essentially betting that an overvalued stock will eventually drop in price. You borrow the shares, then sell them to a buyer who’s willing to pay the current market price. And if the stock’s price declines after you sell, you buy it back at the new lower price and return the shares to the lender. Where you make money is in the gap between the buy price and the sell price.

The main risk with shorting overvalued stock during periods of market volatility is the potential for a trend to reverse. You may invest in a stock that you think is certain to drop in price, but if that doesn’t happen and the stock’s price actually begins to rise instead, you could lose money.

That’s why knowing how to identify overvalued stocks is so important. Since this type of investing strategy is speculative, it’s important to minimize room for error as much as possible. That means being able to lock in on overvalued stocks that are in a downward trend and are likely to continue following that trend for the near-term at least.

How to Spot an Overvalued Stock

Man using a binocular

If you’re on the hunt for stocks that are overvalued, studying certain ratios can help point you in the right direction. These ratios can be the most useful when gauging whether a stock is overvalued or undervalued.

  • Price-to-earnings (P/E) ratio. Price-to-earnings ratio measures a stock’s current share price relative to its earnings per share. Earnings per share means the net profit of the company divided by the number of outstanding shares of common stock. A high price-to-earnings ratio could be a sign that a stock is overvalued.
  • Price-to-earnings-growth (PEG) ratio. Price-to-earnings growth is a company’s P/E ratio, divided by its earnings growth rate measured over a set time period. A higher PEG can signify an overvalued stock, while a lower PEG can mean a stock is undervalued.
  • Price-to-dividend ratio. If the stock in question pays dividends to investors, you might also consider the price-to-dividend ratio to determine value. This ratio measures how much an investor has to pay to receive $1 in dividends. Dividends represent a percentage of a company’s earnings but not every stock offers them.
  • Price-to-sales ratio (P/S). The price-to-sales ratio can be used when a stock’s P/E ratio can’t be measured. This ratio represents the current stock price divided by the sales per share. The higher the ratio, the more likely it may be that a stock is overvalued.

Other factors and trends can help you spot an overvalued stock as well. For example, look at the current demand for the stock and what’s driving it. If there’s a sudden surge in buying activity, the result could be a rising per-share price that may not have happened otherwise. That could lead to stock prices becoming inflated.

On the flip side, look at selling activity. If high-profile investors are selling their shares in the company, that may indicate that the stock is overvalued. The same goes for insider trading, which the SEC keeps public track of. On the other hand, if investors are sitting tight that could mean they’re more confident in the stock’s value and its potential for continued price appreciation.

Going back to a company’s fundamentals can give you insight into what’s driving value and whether the stock is priced fairly in relation to earnings and demand. Earnings reports can be useful when analyzing short-term trends and forecasting a company’s potential for long-term growth.

Finally, pay close attention to what’s happening in the market in general. During periods of market volatility, for instance, stocks can flip flop between bearish and bullish in a single day. If something significant is happening to shake up the U.S. economy or the global markets as a whole, that can complicate how easy it is to identify overvalued stocks for a shorting strategy.

The Bottom Line

A street sign for Wall StreetShort selling stocks that are overvalued could lead to quick profits, but it’s a risky strategy even when markets aren’t as volatile. Certain markers can suggest that a stock is overvalued right away, but it’s always helpful to look under the hood further to get a sense of what’s driving a company’s value and where it might be trending before making an investment. Failure to do so could lead you into a value trap.

Tips for Investing

  • If you’re new to short selling and other advanced trading strategies, it’s a good idea to work with a professional. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • Whether you’re considering getting started with investing or you’re already a seasoned investor, an investment calculator can help you figure out how to meet your goals. It can show you how your initial investment, frequency of contributions and risk tolerance can all affect how your money grows.

Photo credit: ©iStock.com/kemie, ©iStock.com/Sezeryadigar, ©iStock.com/StuartBlyth

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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