Bubble Trouble? Identifying 3 Overvalued Stocks Before They Burst.

Stocks to sell

The Buffett Indicator signals a significantly overvalued U.S. Stock Market and has drawn much attention to overvalued stocks to watch. With market cap over GDP at 192.6%, analysts expect returns to be only 0.6% a year including dividends from this level of overvaluation. Below, you’ll learn about three particular stocks that are overvalued but should be watched.

Explore the possibility of these stocks being overpriced by looking at their P/E Ratios and PEG ratios. Then, examine their intrinsic values using a discounted cash flow (DCF) methodology. Peter Lynch’s principles state the best time to buy is when P/E is under 15 and PEG equals 1. This denotes a fairly valued company. If PEG exceeds 1, it signals an overvaluation. The DCF models will calculate intrinsic values to compare against current prices.

We’ll aim to reasonably assess the growth prospects factored into the stocks’ current valuations. With the overall market appearing frothy when looking at metrics like the elevated S&P 500 P/E ratio of 28.5, these picks may be primed for a comedown.

ARM Holdings (ARM)

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ARM Holdings (NASDAQ:ARM) is a leading designer of chips and intellectual property in the semiconductor industry.

The company appears significantly overvalued based on its sky-high valuation ratios and large discrepancy between current price and intrinsic value. Currently, ARM trades at a P/E ratio of 568.44, one of the highest in the U.S. stock market. Its current PEG ratio is also extremely high at 6.9, far exceeding Lynch’s fair value level.

In addition, the intrinsic value of ARM Holdings using a discounted cash flow (DCF) model is $28.13 per share. This is vastly lower than the current share price of $166.94. Therefore, this indicates ARM trades at nearly five times its intrinsic value.

Stretched valuations based on expected growth and future cash flows suggest ARM Holdings may have overshot its mark. As an intellectual property company tied heavily to the semiconductor cycle, growth is likely to moderate moving forward. Thus expectations seem poised for a reality check.

Given the extremely high P/E and PEG ratios and the enormous gap between price and intrinsic value, ARM Holdings looks like one of the overvalued stocks to watch. Investors may want to wait for a better entry point before buying into the ARM growth story. A correction seems likely to materialize before too long.

TransDigm Group (TDG)

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TransDigm Group (NYSE:TDG) designs and creates products for use in commercial and military aircraft platforms. It’s also likely to soon fall from its pedestal. The company trades at an extremely high P/E ratio of 52.4, over 3 times higher than Peter Lynch’s standard. In addition, the company’s PEG ratio stands at a sky-high 5.02.

Most concerning is the massive discrepancy between TransDigm’s current share price and its intrinsic value. Based on a discounted cash flow valuation model, TransDigm’s intrinsic value is estimated at only $237 per share. This represents an overvaluation compared to the actual stock price of $1,288.65.

The market’s valuation of TransDigm’s future cash flows appears overinflated. It’s true that the company operates in an attractive aerospace industry and produces specialized proprietary products. However, its growth prospects don’t seem to justify such a disconnect with intrinsic value.

With warning signs evident in skyrocketing P/E and PEG ratios far above baseline values, plus an intrinsic value less than one-fifth of the current price, TransDigm shapes up as one of the more overvalued stocks that investors may want to avoid.

Teradyne (TER)

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Teradyne (NASDAQ:TER), a leading supplier of automated test equipment and robotics solutions, appears significantly overvalued based on its current valuations. The company has an exorbitant P/E ratio of 56.47, nearly four times Lynch’s benchmark. Its PEG ratio is equally concerning at 6.85.

Additionally, Teradyne’s intrinsic value is approximately equal to its current price of $147.57 per share. This indicates the stock is trading at more than twice its intrinsic value.

While Teradyne generates strong cash flows and maintains a leading market position, its growth prospects are uncertain. The company has experienced slowing demand for its chip testing equipment over the past few quarters amid customers’ more cautious capital spending. Furthermore, its revenue has declined 3% and earnings missed estimates in the most recent quarter.

Further, stretched valuations seem to price in flawless execution of growth for years to come. So, Teradyne stock appears vulnerable should the growth projections hit any major roadblock.

Given the red flags around growth and the extreme disconnect between price and intrinsic value, Teradyne is another overvalued stock to watch before a potential bursting. At these levels, TER seems to carry significantly more downside risk than upside potential. More patient investors may prefer to watch it from the sidelines until valuations revert closer to historical norms.

On the date of publication, Andrea van Schalkwyk did not hold (either directly or indirectly) any positions in the securities mentioned. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Andrea van Schalkwyk is a value investor who adheres to the principles of the renowned Warren Buffett and his mentor Benjamin Graham. He holds a Master of Engineering (MEng) from the University of Padua and an Executive MBA from the CUOA Business School.

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