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How To Recognize an Overvalued Stock

By Jason Markum

Investing in the stock market is hard, really hard. There’s nothing worse in the world than investing in a stock that turns out to be overvalued. The same thing happens every time; the stock starts to dip, then it starts to drop, then it falls out of the sky and there’s nothing you can do about it.

Sometimes a stock will drop so much that it may take years to climb back to the level at which you bought it. Nobody wants to be caught in a situation where their stock price is underwater and there’s nothing they can do about it. Hopefully this article will give you some tips so that you never find yourself in this exact situation.

So how do you decide or determine whether or not a stock is overvalued? There are many ways to do this and all of them include research and analysis on your own part before investing.

One of the very best ways to determine whether a stock is overpriced is to look at the price/sales ratio or PSR as it is sometimes referred to. The PSR is the price per share divided by the sales per share. If this number is greater than .75 then the stock is way too expensive. This means basically that investors are paying a premium on the future growth of the company. If this is the case then the stock price doesn’t have anywhere to go but down in most circumstances.

Another really great indicator that the stock may be overvalued is insider selling. If management doesn’t want to own shares in the company stock, this is a very good sign to tell you to stay away. You can see what company insiders are doing as far as buying and selling stock by checking with the SEC and looking up the company at the SEC’s website. It doesn’t cost any money to do this, it just takes some time to read the reports.

If you don’t like doing that sort of research on your own, there are newsletters you can subscribe to… for a fee… that keep an eye out on stocks and monitor insider selling of the stocks. Some of these newsletters are fairly expensive but if you do a lot of trading and you have a substantial investment account, the price may be well worth it in terms of time-saving on your part.

Finally, look at the book value of the stock. High PSR stocks more often than not also have high price-to-book values. A book value is usually just the companies assets minus all their liabilities. If a company is selling at less than book value then chances are it’s undervalued and the stock price may increase over time. On the other hand if a stock is already selling at higher than book value then the potential for future growth may already be factored into the overpriced shares of the stock.

However you do it, make sure you have a recognizable strategy when it comes to valuing stocks to determine whether or not they’re overvalued or not. A little bit of extra effort before you buy a share can pay off in spades in the long run.

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