5 Ways To Tell If A Stock Is Overvalued

Investors who buy and sell individual stocks should have an investment philosophy to help guide their decision-making. One approach that’s used by some of the all-time best investors, including Warren Buffett, is to focus on a company’s intrinsic value, or what a stock is worth based on the underlying business’ future results. When a stock sells for significantly less than its intrinsic value, it presents a good investment opportunity, and when it sells for more than its intrinsic value, the stock should be sold or avoided as an investment.

Fortunately, investors can use some simple ratios and signals to help determine whether a stock is cheap or expensive. It’s worth noting that no single metric is perfect, and any use of these ratios or signs to determine business value should be considered along with a complete analysis of the company’s business and industry.

1. Valuation multiples are elevated

One of the quickest ways to get a gauge of a company’s valuation is to look at ratios that compare a stock’s price to a measure of its performance, such as earnings per share. By looking at these ratios and comparing them to other companies in the same industry as well as the overall market, you can get a sense of how the company is being valued. If the valuation multiple is above that of key competitors, it could be because the stock is overvalued.

Here are some of the most popular valuation ratios. The best brokers for stock trading may include many of these ratios on a research page, helping you assess things more quickly.

P/E ratio

The price-to-earnings (P/E) ratio is one of the most widely used ratios in investment analysis, and a high P/E ratio could be a sign that a stock is overvalued. The P/E ratio compares a company’s stock price to its earnings per share and is a way for investors to know how much they’re getting in earnings power relative to the price they’re paying for the stock. Generally speaking, it is better to pay a low P/E ratio than a high one, but there are many exceptions to that rule.

The P/E ratio can be thought of as a way to measure the market’s view of a company’s future earnings growth and the confidence it has in the growth becoming reality. High-growth companies tend to trade at higher P/E multiples than low-growth companies, but moderate- or low-growth businesses may also trade at elevated multiples if the market has a high degree of confidence in the outlook.

Example: Amazon (AMZN) currently trades at a P/E of about 33 as of April 2025, while the more economically sensitive homebuilder D.R. Horton (DHI) trades at a P/E of about 9.5. 

EV/EBIT

A high enterprise value (EV) to EBIT ratio could also indicate a stock is overvalued. The EV/EBIT ratio is very similar to the P/E ratio, but it uses more than just price and earnings-per-share in its calculation. EV accounts for debt that the company may use for financing and EBIT is an acronym standing for earnings before interest and taxes.

EV can be calculated by adding a company’s interest-bearing debt, net of cash, to its market capitalization. Next, by using EBIT you can more easily compare the actual operating earnings of a business with other companies that may have different tax rates or debt levels.

Example: Tesla (TSLA) currently trades at an EV/EBIT multiple of about 105 as of April 2025, compared to General Motors’ (GM) multiple of about 12.

Price-to-sales

The price-to-sales (P/S) ratio is a fairly simple ratio that is calculated by dividing a company’s market capitalization by its revenue over the previous 12 months and a high ratio could be a sign that a stock is overvalued. This ratio can be useful for companies that have low or negative earnings due to one-time factors or are in their early stages and investing heavily in the business. Remember that generating sales is not the ultimate goal for an investor, but rather profits. So, beware of companies touting how attractive their stock is on a price-to-sales basis if they haven’t proven they can generate actual earnings.

The software industry is an area where the P/S ratio may be useful in valuation analysis. Software companies can be extremely profitable, but often invest capital heavily during the early stages of their business, causing them to show losses. By using the P/S ratio, you can get a sense of the valuation despite reported losses.

Example: Microsoft (MSFT) currently trades at a P/S ratio of about 10.5 as of April 2025, while Salesforce (CRM) trades at a multiple of about 6.3. 

2. Company insiders are selling

Another way to tell if a company might be overvalued is to pay attention to what company insiders are doing with their shares. Employees and executives typically understand their business better than anyone, and if they’re selling shares, it could be a sign they think the company’s future success is more than priced into the stock. Insider transactions are reported in filings with the Securities and Exchange Commission and accessible through the agency’s website.

But here again, there are exceptions to the rule. Insiders may sell for any number of reasons that have nothing to do with what they think about the company’s valuation.

• They may sell to cover taxes on a share grant they received.
• They could be rebalancing their overall portfolio.
• They may just need the money for a purchase like a house or a car.

Conversely, insider buying likely indicates that they believe the stock is attractive. While sales can happen for many reasons, executives typically buy for one reason: they think the stock is a good investment. Be sure to read the filings carefully, though. An insider who is awarded shares as part of their compensation is not the same thing as an executive using their own cash to buy shares in the open market.

3. PEG ratio

The price-to-earnings growth ratio, or PEG, is a way to compare the P/E ratio to a company’s growth rate. A high P/E ratio for a fast-growing company may make a lot of sense, so it’s important to understand the growth outlook before making a judgment solely based on the P/E ratio.

A PEG ratio above 2 is typically considered expensive, while a ratio below 1 may indicate a good deal. As with any metric, the ratio is only as valuable as the information used to calculate it. If your projections about future growth are off, the ratio won’t have much value to you.

4. The economic cycle is about to turn

Some companies are cyclical in nature, meaning that their profits rise and fall with the overall economic cycle. These businesses can be some of the most difficult to value because they sometimes appear cheap based on ratios like P/E just as the economic cycle is about to roll over. Conversely, they can appear expensive when their earnings are depressed, which causes the valuation multiples to be inflated. But these depressed earnings may be at a trough in the economic cycle, the exact time when the stocks are most attractive – right before the company grows profits quickly.

If you find a cyclical business trading for a low multiple, make sure you consider the economic cycle and whether things might turn for the worse. An apparent bargain may actually be an overvalued stock.

5. Relative dividend yield

You can also use a company’s dividend yield as a clue to whether the stock may be expensive. Relative dividend yield compares the yield on a stock to the yield on the overall market. You can compare a company’s historical relative yield to get insight into whether it’s currently overvalued or undervalued.

To be sure, there can be very legitimate reasons why the relative dividend yield may have changed. Maybe the company has better growth prospects than it did historically, and the company’s dividend yield has declined as a result of investors pushing up the share price. You always want to make sure you’re analyzing the fundamental business and not just drawing conclusions based on a single measure of value.

Bottom line on overvalued stocks

Valuing a business is oftentimes more of an art than a science. But looking at valuation ratios, what company insiders are doing and where we are in the economic cycle can all provide clues as to whether a company is overvalued or not. Enterprising investors can also check out some of the best investing books to get more tips from investing experts.

Remember that there is no magic formula when it comes to investing and you shouldn’t ever rely on just one or two metrics to make a decision. Work to understand a company’s future outlook and if you can’t reach a conclusion, you may be better off not owning the stock at all.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.