Why Do People Say Stocks are “Overvalued” Right Now?

The more I learn about investing, the more I realize I don’t know shit.

Seriously – I mean that.

There’s always more to learn, so it’s good to continuously be humbled by your own ignorance. That’s why I do my best to listen to new podcasts, read new blogs, and waste money on books I could rent from the library as much as my schedule permits so I can be exposed to all the various topics and concerns of the hoi polloi – and make sense of them for you.

One of the things that’s been consistently present in a lot of this content recently is the idea that stocks are “overvalued.”

While it’s difficult to conceptualize what that even means for something so abstract, you could make a worthwhile comparison to the housing market to get the gist – a lot of people say houses are “overvalued” right now, too. In other words, they cost more than they’re worth, so if you buy one now, you’re overpaying.

That’s kinda challenging when it comes to investing, no? How are you supposed to know? Should you keep investing anyway?

Why do people say that stocks are “overvalued” or “expensive”?

It’s easy to look at two things that you understand and say if one of them is more expensive than the other. But why would someone say a stock is expensive or overvalued?

Let’s pretend that Money with Katie is a public company (woohoo! IPO!) and that there are two shares – meaning ownership of Money with Katie is chopped in two. Now let’s pretend you buy one of the shares for $50, so we’re co-owners. Nice to meet you, partner. You got a bargain.

Now let’s pretend that Money with Katie makes $10,000 per year.

If there are two shares of Money with Katie – yours and mine – that means we’re the only two shareholders who split the revenue.

To figure out the earnings per share, we’d divide our earnings – $10,000 – by our number of shares, 2.

That’s an earnings per share of $5,000.

You paid $50 your share of Money with Katie.

So to figure out whether or not that price was expensive or not, we’d take the price of the share ($50) divided by the earnings for that share ($5,000) to get 0.01. That would suggest the stock is way undervalued, since you can own half of Money with Katie for only $50, but earnings on that share are $5,000.

But what if I charged you $10,000 per share? Money with Katie makes $10,000 per year, but in order for you to own half of it (or get $5,000 per share, per year), I want $10,000. You’ll get $5,000 in earnings on your $10,000 share each year, theoretically.

Now, the price per share ($10,000) divided by the earnings per share ($5,000) is 2. The share price is twice as much as your earnings for that share.

But hey, you break even after two years! And after that? It’s all gravy, baby. A great value indeed, if you think Money with Katie is going to the moon.

A lot of companies are “overvalued” by this measure, because theoretically, you’re betting on the future of that company. If you could own half of Money with Katie for $10,000, that may be a wonky ass deal after the first year of earnings since you know that it only made $10,000 total. But what if it was projected to make $100,000 next year? Now, your $10,000 investment to own half doesn’t sound so bad.

This example is funny because we’re pretending there are only two shares, so the numbers probably feel a little extreme. Apple, for example, has about 16 billion shares outstanding.

What does shares outstanding mean?

“Shares outstanding” basically just means how many little pieces are out there floating around owned by people. There are 16 billion shares of Apple available, and they’re each worth about $125. That means the total “value,” also known as “market capitalization,” of Apple is $2 trillion.

(16 billion shares * $125 each = about $2T, as of May 23, 2021.)

So Apple is technically “worth” $2T. In 2020, Apple reported a net income (profit) of $57B.

Each share costs $125, and there are 16 billion of them.

That means the earnings per share in 2020 was $3.50. Divide the stock’s price ($125) by the earnings per share ($3.50) – Apple is trading for 35x its earnings per share. Put another way, you pay $125 per share to get $3.50 in earnings.

But it begs the question: Do you think Apple will continue to grow aggressively? Or, do you think it’s overpriced?

If you’re like, “Shit, I don’t know,” that’s the point. It’s hard to know. Nobody knows whether Apple will make $100B in profit next year or earn less. There are simply too many factors that impact both its performance as well as the price of its stock.

This is far from the only metric you can look at to determine how the stock market, as a whole, is doing

The upshot is that you can look at different indices as a whole (like the S&P 500) and determine collectively if it’s “undervalued” or “overvalued” as defined by this ratio, and some people point to periods before previous downturns where it was overvalued as a sign that an overvalued market means a downturn is coming.

Maybe, maybe not.

But now you know!

My head hurts.