Lakhan: Hi Ram! Good morning. Is it a good time to talk?
Ram: Good morning Lakhan. Yes. Go ahead.
Lakhan: I am looking forward to buying shares of a company. However, I doubt that the price reflected is higher than its fair value.
Ram: Hmm. In that case, I feel it’s an overvalued share.
Lakhan: Can you please explain?
Ram: You see, sometimes companies inflate the intrinsic value of their shares which makes them trade at a higher price. In such a scenario, a share is said to be overvalued.
Lakhan: Are there any concrete ways to identify if a share is overvalued or not?
Ram: Yes, there are ways to do it.
Lakhan: What are they?
Ram: Price to earnings ratio, dividends, stock market capitalization to GDP ratio, among others are some ways through which you can say if a share is overvalued or not.
Lakhan: It will be great if you can explain to me how to use these parameters.
Ram: Definitely. Let’s start with price to earnings ratio. Commonly known as PE ratio, it is calculated by dividing the stock’s price with a year’s (12 months’) earnings per share. If you see this ratio high, then in all probability it’s an overvalued share. When it comes to dividends, these have an inverse relation with share prices. What it means is that when dividends are high, prices are low. But if you see the opposite, then the share may be overvalued.
Lakhan: What about market to GDP ratio?
Ram: Market to GDP ratio is computed by dividing the stock market capitalization of all the listed stocks with the annual GDP of the country. Investment sage Warren Buffet popularized its use and therefore, it’s also known as Buffet indicator. If it ranges between 90-115%, then probably the share is a little overvalued.
Lakhan: If I find that the share is overvalued, should I invest?
Ram: You see when a share is overvalued then there are chances of its value coming down in the future. If it happens, then you might incur losses on your investment. Hence, it’s crucial for you to first understand whether a share is overvalued or not and then take a decision. If you are satisfied that it isn’t, it makes sense to invest in them.
Lakhan: Thank you for your guidance Ram.
Ram: My pleasure Lakhan.
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