What is Overvalued?
Overvalued describes a security for which the market price is considered too high for its fundamentals. Some metrics used to evaluate whether a security is overvalued are: P/E ratio, growth potential, and balance sheet health. The term is the opposite of undervalued.
A stock may become overvalued in one of two ways. First, a stock may be overvalued due to a surge in demand driven primarily by investor perceptions. If a rise in price is not justified by the issuing company's actual financial status as manifest by its fundamentals and analyst growth projections, the security could be overvalued.
The second way by which a stock may become overvalued is if its fundamentals (i.e. revenue, earnings, growth projections, balance sheet, etc.) decline while its market price remains constant. If the security was already fairly valued and does drop in price when the fundamentals deteriorate, then the security is likely valued adequately.
Overvalued should not be confused with undervalued, which is the opposite case, wherein the price of a stock is too low given its earnings, growth potential, and financial status.
Why Overvalued Stocks Matter
A stock which is considered to be overvalued is likely to experience a price decline and return to a level which better reflects its financial status and fundamentals. Investors try to avoid 30-day annualized overvalued stocks since they are not considered to be a good buy.
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