Six ways to spot overpriced shares

Stockmarkets may be soaring, but most gains are being driven by a glut of cheap money rather than solid fundamentals. So you need to be sure the shares you're buying can stand a market retreat.

Last week the Dow Jones burst through the 13,000 level to set a new record, while the FTSE 100 is hovering at less than 10% below its all-time high. As Al Goldman of AG Edwards told the FT: "We have come awful far, awful fast." The danger, as investment bank Morgan Stanley points out, is that gains are being driven more by cheap money and merger fever than solid fundamentals. As Warren Buffett always says, "a rising tide tends to lift all boats", so how can you avoid buying a share that is overvalued and will be exposed if the market retreats? Here are six signs to watch out for.

Spot overpriced shares: High p/e or low earnings yield

The price to earnings (p/e) ratio is the relationship between the current share price and one year's earnings per share (EPS: normally given at the foot of the profit and loss account). If you plan to buy a share with a p/e of say 30, are you prepared to wait 30 years (ignoring inflation) to break even, based on current earnings? Probably not. More likely you expect market-beating earnings growth and a much quicker return. That's all very well, but high expectations can easily be disappointed. For example, the UK retail sector's p/e of 22 looks ambitious (at 1.7 times the FTSE 100 average of 13) given the potential impact of yet more interest rate rises on consumer spending.

Another way to look at this is to calculate the earnings yield just divide one by the p/e ratio. So a p/e of 22 gives an earnings yield of 4.5%. This again implies that investors expect significant earnings growth, given that many bank accounts offer a higher yield for less risk.

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Spot overpriced shares: Falling dividend yield

It may seem conservative, but a policy of paying consistent dividends imposes discipline on management teams and guarantees the investor at least some real returns. The yield is one year's dividend divided by the current share price. A sudden dip could be caused by several factors including a change in dividend policy. But it can also be a warning that the share price has risen too far, too fast.

Spot overpriced shares: High price to earnings growth ratio

The PEG ratio compares the p/e ratio with earnings growth. So if last year's EPS was 10p and this year's is forecast to be 12p, the earnings growth rate is 20%. If the p/e ratio is 30, that makes the PEG 1.5. A PEG much higher than one can be an indicator of an overvalued stock, in this case possibly by as much as 50%. Take Bespak (LSE: BPK). Commentary in the last interim results statement implies earnings growth of around 15%, which seems healthy enough. But on a current p/e ratio of 22, the PEG is 1.46 times which, as Motley Fool comments, makes this growth look expensive.

Spot overpriced shares: High price to book ratio

The price to book (p/b) ratio compares the stockmarket price of a share with the asset book value per share from the accounts. Assume a company has £100m in assets on the balance sheet and £75m in liabilities. The book value of that company would be £25m. If there are 10 million ordinary shares outstanding, each represents £2.50 of book value. If the share price is £5, then the p/b ratio is two (5/2.50). At less than one there may be a bargain available, but at 2 or above, value investors should ask questions.

The warning lights should really start flashing when this is combined with a low or falling return on equity (see below). As a rule of thumb, the price to book ratio is most useful when looking at companies with a high tangible asset base like investment trusts or property firms, but less reliable for those that are earnings driven, highly geared or have most of their value tied up in intangible assets. For example, software companies like Microsoft often change hands on a p/b of 10 or more. This would be far too high for a property firm like British Land.

Spot overpriced shares: Low return on equity

RoE is a useful guide to the return that shareholders receive for investing their money with a company. The ratio is calculated by dividing net income or profits (after preference dividends and minority interests), by balance sheet shareholders' equity (either using the year-end figure or an average of opening and closing). Let's say net income is £5m, and average shareholders' equity is £165m. That gives a return on average equity of around 3%. That's worse than the yield on gilts for far more risk.

High p/b ratios and a falling RoE can indicate a strong performer that may now be overpriced and passing its prime (that is, the shares are still doing well, but returns have peaked). For example, JJB Sports, a recent retail star, now looks less attractive with a p/b ratio of nearly two, combined with falling return on equity (down from 12.1% in 2005 to 7.6% in 2006, according to Hemscott) and operating in a highly competitive sector.

Spot overpriced shares: The boss is selling

This is an easy one; if those closest to the business, its directors, are selling, you should always consider following their lead after all, they should know the business better than anyone. In November, John Ritblatt sold most of his remaining shares (3.5m) in British Land, apparently planning to reinvest the proceeds in China and India. Many analysts saw this as a sign that the best days of UK commercial property may be over and we certainly wouldn't disagree. To keep up to date on when directors are selling, see: Director dealings