Q: Could you explain to me what it exactly means when a stock is overvalued and when it is undervalued? Which one of them is more attractive for investment considerations? — Ana R. , Santa Monica, Calif.
A: You always want to go with stocks that are undervalued -- and sell when they're overvalued. The problem is trying to figure out which is which.
"Undervalued" is Wall Street jargon for "cheap." If Costco is selling your favorite new TV for $10 less than the same model at Wal-mart, you might say the Costco TV is "undervalued" -- the store has attached a value to it that's less than a comparable TV offered by another seller. On the other hand, if someone on eBay is willing to pay $50 more for the same TV, it's "overvalued" on eBay.
The tougher part is figuring out what the "right" value is for a stock. Most investors historically have used a company's earnings power as a measure of its value. If earnings are strong, and going up, chances are good the stock price will too.
So now you're trying to buy a stock with good earnings as cheaply as possible. That's what "earnings per share" data and "price-earnings" ratios are for. It's simply a way to compare how much you're paying for a dollar of earnings from one company to the next. Or one industry to the next. Or one month to the next. Stock prices may change on a daily basis, but the earnings -- the "E" of the P/E ratio -- are fairly easy to nail down (as long as you believe the company's accountants). The "P" represents earnings per share -- the total profit divided by the number of shares out there on the market.
So if you can buy a stock for 10 times earnings when the company's competitors are selling for 20 times earnings -- your stock may be "undervalued." (It also could be priced lower than its peers because its in serious financial trouble -- that's why these terms are so imprecise.)
When your broker tells you he wants you to buy a stock he thinks is "undervalued" -- ask him to explain why he thinks so. The answer could be very illuminating. (And don't buy unless you fully understand -- and believe -- the pitch.)