You might have seen the phrase Bubble Stocks used in my postings. So what exactly are bubble stocks ?
Well, bubble stocks are stocks which are in a bubble (meh ^^). But the more interesting question is – how do we know that a stock is a bubble stock ?
As a general rule of thumb , a stock is a bubble stock if its PE Ratio is 3 or more times than the average PE Ratio of its business sector. The PE Ratio (Price Earnings Ratio) values the company base on its past EPS (Earnings Per Share) excluding future growth.
PE Ratio refers to the current price one is willing to pay for 1 share of the stock.
A PE Ratio of 10 means investor is willing to pay 10 dollars for 1 share of the company.
The market generally accepts that a PE Ratio of 10 is the generic benchmark of a fairly priced stock.
To calculate PE Ratio, a company should have past EPS (Earnings Per Share) of 5 years or more.
However for companies in their growth phase, it is not accurate to value them by their PE Ratio as the company does not have a long history of EPS yet or the business sector is still not mature yet (think innovative/disruptive sectors).
For such companies, another indicator is used to value them. This is call the PEG Ratio ( Price to Earnings Growth Ratio). The PEG Ratio divides the EPS by the company’s earning growth rate. A company with a higher growth rate will have a higher peg ratio.
As a general rule of thumb , a stock is a bubble stock if its PEG Ratio is 3 or more times than the average PEG Ratio of its business sector.
The market generally accepts that a PEG Ratio of 1 is the generic benchmark of a fairly priced stock. Companies with PEG Ratio of less than 1 are undervalued. Those with PEG Ratio of more than 1 are overvalued.
Comparing Stocks in Electric Vehicle sector (Growth)
Comparing Stocks in Finance sector (Value)
Personally for great companies with many years of history and EPS, I will always compare a stock using its PE Ratio comparing to the average PE Ratio of its industry.
For growth companies, PEG ratio is more applicable.