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Chapter 8: Problem 9

Jay Ritter, a professor at the University of Florida, was quoted in the Wall Street Journal as saying about Facebook: "It's entirely possible for a company to have solid growth prospects while its stock is overvalued." a. What does it mean to describe a stock as "overvalued"? b. Why might a firm's stock be overvalued despite the firm having "solid growth prospects"?

Short Answer

Expert verified
When a stock is described as 'overvalued', it means its current market price is higher than its intrinsic value, which is based on the company's underlying fundamentals and future earnings expectations. A firm's stock might be overvalued despite having solid growth prospects due to overly optimistic investor expectations about future growth, market speculation, or low interest rates fueling increased investments in stocks.

Step by step solution

01

Understanding 'Overvalued' Stock

A stock is considered 'overvalued' when its current price in the market is more than its intrinsic value. The intrinsic value of a stock is usually estimated based on an evaluation of the company's fundamentals, future earnings prospects or some other valuation method. The term 'overvalued' implies that the market price exceeds the value justified by the company's earnings, growth prospect and risk level.
02

Discussing 'Solid Growth Prospects'

When we say that a company has 'solid growth prospects', it means that the company is expected to increase its earnings, or profits, in the future. This could be due to several factors such as favorable market conditions, a competitive advantage, product innovation, etc.
03

Overvalued Stock despite Solid Growth Prospects

A company's stock might be overvalued despite the firm having 'solid growth prospects' due to a variety of reasons. One reason could be that investors have overly optimistic expectations of the firm's future growth and are willing to pay a premium for the stock, driving up its price in the market. Another reason could be due to market speculation, where investors drive up the price of the stock in hopes of selling it off for a higher price later. Another situation could be related to low interest rates, in this case, as alternative investments yield low returns, investors may funnel more money into stocks, pushing up their prices.

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