One of the most important components of the stock market that every successful investor should understand is value. People make decisions to buy shares of public companies based on their value. This value can be true or intrinsic. Intrinsic share value may differ from actual one. But still it is based on own perception of a true share value, which includes all the core aspects of the stock market.
But shares are traded very actively. That’s why their price does not always corresponds to their intrinsic value. Sometimes share price is lower than its intrinsic value. In this case the stock is undervalued. But if share price is higher than its intrinsic value than the stock is overvalued.
Emotions Can Cause Overvaluation
So what are the main causes of overvaluation? Why can’t we buy and sell stocks at their intrinsic value always? The main reason of overvaluation is our emotions. Why? Because investors are often influenced by emotions while trading stocks. And in many cases emotions are even more important factor than the general fundamentals of the business.
Very often investors make decisions about buying and selling stocks based on emotional aspects like, for example, what others are saying about the market or the industry. And sometimes core business fundamentals like a company’s earnings or sales are not considered at all. Also there may be a situation when a broad market selloff is happening. In this case many investors panic and sell their stocks out because they are afraid of losing money.
The dot-com boom of the late 1990s and early 2000s is a great example of overvaluation. The stock prices of dot-com startups were bidden up by investors to extremely high levels. And the main cause of this situation was emotion – excitement and too optimistic expectations about the Internet.
A huge number of Internet startups that were barely afloat reached amazing valuations just because many investors wanted to buy their shares. It was a kind of emotional investing. As a result many shaky Internet startups were extremely overvalued. But soon valuations of many dot-com companies were corrected. Many Internet startups went bankrupt and the stock market plummeted.
What Strategies to Choose?
Every investor should buy shares when they are considered to be undervalued. In other words, the best time to buy shares when their price is lower than their actual value. If you buy overvalued stocks this could lead to huge losses as their price eventually declines.
But how to determine whether the stock is overvalued or not? To do this you need to examine all company’s financial indicators and market fundamentals very carefully. You should assess such indicators as revenue, sales, earnings, P/E growth ratio, company and industry in general growth prospects.
If you perform this kind of examination very carefully you should not only measure yourself by watching Fox Business News or CNBC. Sure reading Investor’s Business Dail is good but definitely not enough. Try to dig deeper into core business fundamentals so that you could determine company’s intrinsic value. This is the only possible way to determine whether the stock is overvalued or undervalued.
James is an expert in stock trading and forecasting