If ever a season of the overvalued broke the bank of speculators, it bloomed 380 years ago — in tulip season, to be precise.
When Tulip Mania peaked in the Netherlands, Gouda bulbs hit 10 times the annual salary of a skilled craftsman. But that was seed compared to a single Viceroy bulb; you could offer up four fat oxen, a dozen fat sheep and eight fat swine, and still come up slim. Then came a colossal crash that same year, and soon the mighty tulip fetched no more than a lowly onion.
As for whether Wall Street has learned all that much in the past four centuries, experts agree that in some cases, investors have traded in the tulips for rose-colored glasses.
One question vexes Paul Irvine, the Kleinheinz Family Foundation Chair in International Finance and Investments at Texas Christian University’s Neeley School of Business: “Why do overpriced stocks exist at all?”
Irvine says “in a perfectly efficient market investors should incorporate the relevant information in stock prices correctly and thus correctly evaluate the future profitability of each stock.”
[See: 7 Ways to Tell if a Stock is a Good Price.]
However, that doesn’t always happen — or rather, the opposite happens all the time.
“Winner stocks tend to become overvalued since their prices rise faster than their earnings growth,” Irvine says. “So by the most common valuation metric — price-to-earnings ratio — they look expensive relative to the near term earnings promised relative to other stocks.”
So while many investors drool at a rising stock price or a sexy investment, this one measure could temper over-enthusiasm for the overvalued. With price-to-earnings ratio, the company’s market value per share is divided by earnings per share. It’s simple to calculate. Then again, so is the amount a taxpayer will owe the IRS, and both numbers prove all too easy to blissfully ignore.
“The more overvalued, the farther the potential fall,” says Bob Johnson, CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania.
Johnson cites the example of Company A selling at 50 times earnings, versus Company B at 10 times earnings.
“Absent any earnings changes, it is much easier for the first stock to drop in value by 50 percent in a bear stock market than the second,” he says.
And these days, finding an overvalued stock is a snap — literally. Johnson points to the IPO of Snap (ticker: SNAP) — makers of the Snapchat app for exchanging photos and short videos. The company public went recently, making many headlines along the way.
“SNAP has a market capitalization of nearly $25 billion on sales of only $404 million,” Johnson says. “It is losing money and selling at a price-to-sales ratio of an astronomical 61 times. Many millennials are buying the stock because they love the product. But just because a company produces a good product, one should not infer that company’s stock is a good investment.”
Elsewhere in the high-tech sphere there’s Facebook ( FB), with a current P/E of 43, based on last year’s earnings. “That’s well above the market average of 29 — an average that is historically quite high already,” Irvine says. “Facebook went public in July 2012 at $38. It has risen to just under $140 with hardly a hiccup along the way.”
Tesla ( TSLA) offers another example of a stock that has yet to make financial good on its sky-high share price. Granted, Tesla is a pioneer in the luxury electric car market. But some investors have been blinded by charismatic CEO Elon Musk. He has fawning fans everywhere who cite his commitments to the environment, quality product and wildly ambitious ideas. (These include a levitating “hyperloop” transport that will move people at 1,000 miles per hour.)
[See: 10 Skills the Best Investors Have.]
That said, there’s a bit of used car salesman in Musk, who has famously predicted Tesla sales will increase 10-fold by 2020. But for all that pie in the sky comes a potential dose of humble pie: Tesla has only reported a profit twice since going public in 2010 — most recently in October. During the same stretch, Tesla stock has soared 1,400 percent, from $17.40 to $261.50 in mid-March, thus making a tulip bubble modest by comparison.
Yet arguments often tilt both ways on what exactly cements a stock as overvalued — and differences of opinion, it turns out, can even pit one billionaire against another.
“In the past year Carl Icahn closed out his position in Apple stock ( AAPL) while Warren Buffett increased his,” says Angelo DeCandia, professor of business at Touro College in New York City. “Clearly overvaluation, like beauty, lies in the eye of the beholder. There are several measures, though not infallible, that help to sound the alarm as to a possible stock overvaluation.”
Aside from P/E, DeCandia also lists the price-to-earnings versus growth ratio, or PEG, as an important consideration.
“A stock trading with a fairly high P/E of 50 can appear more acceptable if its growth rate is 25 percent, a PEG equal to 2,” he says. “Sometimes you have to pay for those fantastic growth rates and PEG lets you know exactly how much it’s costing you.”
And if you’re going to look on the sunny side, there may even be some justification for overvalued winning you over.
“Growth is why we even entertain the notion of acquiring an overvalued stock,” DeCandia says. Then again, value investors won’t be big fans: “If you’re looking for value you’re not going to find it in an overvalued stock.”
Adds Johnson: “There is no margin of safety, which is the cornerstone of value investing. Margin of safety simply refers to the investor’s estimate of how much of a discount the security is selling for relative to its intrinsic or true value. The larger the margin of safety, the more things can ‘go wrong’ and the investor will not suffer a loss.”
And when those losses hit, it’s no bed of roses — or if you prefer, tulips.
[See: 9 Stocks to Buy for the Aging Baby Boomer Market.]
“In the end, overvalued stocks sometimes return the outsized returns that their enthusiasts are searching for,” DeCandia says. “Far too often, however, overpaying is underestimating the many things that can go wrong on the road to excess profits.”
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Pros, Cons of Overvalued Stocks originally appeared on usnews.com
