Wednesday, August 31, 2011

Identify Overvalued Stock

Overvalued Stocks are like a curse for your investment portfolio.
The process of stock investing and seeing ones money grow is an experience of extreme satisfaction. Generally we have a habit of only spending on liabilities which quickly depletes your money forever. But imagine a mechanism which not only saves your money but also makes it grow. Everybody who believes in the concept of savings must take necessary actions to make their money grow.

Growth of money will not only make you richer but it will also protect you form the negativity of inflation. This is very important inflation is making you poorer each day. Even if you are saving heavily (but not making your savings grow) but the effect of inflation is eroding the strength of money each day. Twenty years back the same $100 could buy you a small television which in today’s scenario impossible. Inflation is reducing the purchasing power of your money with the passage of time.

In order to protect your money form inflation and to make it grow further, stock investment is the best option available. Taking the records of past 30 years, the rate of inflation is Asia is hovering around 9% and stock market has given an average return of more than 12%.

One can expect to get a much better returns form stock market investments (more than 12%) if you pick your stocks carefully and judiciously. But stock investing becomes awful for those investors who do not time the purchase of their stocks and just go by other people advice. Such investors often bags overvalued stocks in their portfolio. Overvalued stocks are nothing but those stocks which has been purchased by investors at their peak prices.

When an investor buys overvalued stocks it takes them only a while to realize their mistake. The stock price soon begins to fall and their portfolio always shows in red. It is very important for all stock investors to identify overvalued stock and avoid its purchase till its price falls to acceptable levels. Today we will discuss how to identify overvalued stocks.

There are some very easy ways of identifying overvalued stocks. Before buying any stock just keep a tab on the below discussed points. This will give you assurance that at least the prices of these stocks are not overvalued.

Compare book value with market price of stock
One of the best and easiest ways to identify an overvalued stock is to compare the present market price of stock with its book value. One can say that Book value is the cost of stock that company thinks must be paid by investors to own one of them. Any additional price paid by an investor (above book value) is a decision of investor with an expectation that the stock price has ability to rise in time to come. Ideally all stocks must e purchased at or below its book value. Book value of a company appears in the financial reports of a company and also published by financial websites.

Price/Sales Ratio (PSR) should not be more than 0.75

This is another way of effortlessly identifying an overvalued stock. Take out a note pad and divide net sales by number of outstanding stocks (X). When you obtain the X simply divide present market price by X, this will give you a value of PSR.

Lets take an example. Suppose the market price of a stock is $40, Net Sales $7800,00,00,000, Outstanding Shares 133,03,38,317 Nos. Then X = $7800,00,00,000 / 133,03,38,317 = $58.6 and PSR = $40 / $58.6 = 0.68

In case the value of PSR is more than 0.75 it indicates that the stock is overvalued. Try to avoid this stock till it reached a value below 0.75 margins.

Inside Selling of Stocks indicates that company considers present market price as overvalued
This is also a great indicator of knowing whether a stock is overvalued or not. When the insiders of the company start selling their stocks then it is clear indication that the price of stocks is hovering around its peak. Selling of stocks by companies means they expect the prices to fall down in times to come.

This is a standard practice by all companies; they buy their stocks at very low levels and sell at high. But in order to get these information’s that when a company is selling and buying is a trick of this game. A qualified investor builds his contacts and keeps a track on company’s decisions.
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