When Is a Stock Too Expensive?

Flash Points:

  • Defining what’s expensive is relative
  • Paying a high multiple is sometimes justified
  • Buy on fundamentals not valuation
  • However, valuations are a useful gauge for timing

Bargain Hunting for Stocks

Picking stocks often becomes an arduous affair, replete with decisions and choices. For some, it’s a daily occurrence, akin to second nature.

With the increasing number of platforms made available today, investors can now access various markets & exchanges – thus being easily left spoilt for choice.

But a recurring question investors commonly ask is when a stock becomes too expensive?

Put more simply, we all know when we are overpaying for items like smartphones, clothing, laptops, etc. – we check against the quality of the material, brand recognition, its unique features and utility value.

But how can investors evaluate the same for stocks and determine when you’re overpaying for one?

What do we mean by ‘expensive’?

If one believes the Efficient Market Hypothesis (EMH) which states that the price of assets will factor-in or discount all available information – then the value of a stock should be reflective of its fair value at that point in time.

It does not mean that one cannot make money from stocks trading at their fair value – as long as the underlying business continues to grow, we believe its share price will chart higher to reflect the improved growth.

In other words, the fair value increases over time as its business grows.

Sceptics may argue against EMH, but markets tend to be fairly efficient and react to these positive or negative catalysts accordingly.

Factors like a loss of key management personnel or major customers, adverse regulation, natural disasters, etc. can affect the firm’s fundamentals and its ability to deliver earnings growth.

We think a stock is deemed ‘expensive’ or overvalued when its valuation is not reacting fast enough to these negative changes.

Or the value ascribed runs ahead of its fundamentals & earnings growth potential.

Alternatively, one could also take a different view from what the market thinks due to different interpretation of facts governing the fair value of the stock.

Thus, defining whether a stock is ‘cheap’ or ‘expensive’ is relative and depends on more than just the valuation itself.

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