How to Know If a Stock Is Overpriced or Undervalued: A Practical Guide to Stock Valuation

Have you ever wondered whether you're overpaying or getting a good deal on a stock? That’s one of the most common questions among investors—and for good reason. The price you pay for a stock can make or break your investment. In this article, we’ll break down how to know if a stock is overpriced or undervalued, using practical examples, spreadsheets, and real numbers.

Let’s walk through a simplified valuation method you can apply today—even if you’re not a finance expert.

What Is Stock Valuation?

Stock valuation is the process of determining a company's fair value—what it's truly worth based on the cash it’s expected to generate in the future. By learning how to value a stock, investors can make more informed decisions and avoid the trap of buying “great companies” at terrible prices—or buying “cheap” stocks that turn out to be bad investments.

Why It Matters

Even a great business can become a bad investment if you overpay. Likewise, buying a weak company at a low price likely won’t pay off either. Understanding what a stock is worth helps you identify true opportunities in the market.

Step-by-Step: How to Know If a Stock Is Overvalued or Undervalued

We’ll walk through a practical method based on the Discounted Cash Flow (DCF) model. This approach involves three key steps:

1. Set Your Assumptions

Everything starts with good assumptions—also called “inputs.” These are estimates about the company’s growth rate, tax rate, return expectations, and more. Here's a simplified example:

• Perpetual growth rate: 3% per year

• Required return on equity: 8% above the long-term interest rate (e.g., the U.S. 10-year Treasury rate)

• Tax rate: 34%

These numbers are placeholders—you can adjust them based on your own research.

2. Calculate the Discount Rate (WACC)

The discount rate is how you adjust future cash flows to reflect their value today. In this model, we use the Weighted Average Cost of Capital (WACC), which blends the cost of equity and the cost of debt.

Here’s how it breaks down:

• Cost of equity: For example, 12.55%

• Cost of debt: Around 4%

• Capital structure: The ratio of debt and equity on the company’s balance sheet

Based on these numbers, our sample company—let’s say it’s a U.S. healthcare firm similar to Fleury—has a WACC of 7.27%.

3. Estimate Free Cash Flow to the Firm (FCFF)

With the discount rate set, we estimate the Free Cash Flow to the Firm (FCFF) using this formula:

FCFF = NOPAT + Depreciation – CapEx – Change in Working Capital

Example values:

• NOPAT (Net Operating Profit After Taxes): $269 million

• Depreciation: $325 million

• CapEx: $189 million

• Change in Working Capital: –$483 million

• FCFF: $888 million

4. Project Future Cash Flows and Discount Them

Assuming the company grows its FCFF by 5% annually for three years, and then settles into a 3% perpetual growth rate, we discount each year’s cash flow back to today’s value using WACC.

We also calculate the terminal value using the formula:

Terminal Value = FCFF in Year 3 × (1 + g) / (WACC – g)

Where g is the perpetual growth rate.

Finally, sum all the present values of the projected FCFFs and the terminal value to get the Enterprise Value.

In our example, that total value came out to approximately $20.7 billion.

Final Step: Estimate the Fair Price per Share

Let’s say the company has 317 million shares outstanding. To estimate the fair price:

Fair Price = Total Company Value / Shares Outstanding

So, the estimated fair value per share would be $65.42. If the stock is currently trading at $26.95, that implies a potential upside of 142%.

What If Your Assumptions Change?

This is where valuation gets dynamic. Small changes in your assumptions can dramatically change the result:

• Higher discount rate (WACC)? Lower fair value

• Lower growth rate? Lower fair value

• More optimistic projections? Higher fair value

That’s why it’s so important to update your model regularly with earnings reports, industry trends, and economic conditions.

Conclusion: A Simple Valuation Model Can Go a Long Way

Understanding valuation doesn’t require a PhD. With a basic spreadsheet and a clear methodology, you can assess whether a stock is worth its current price—and avoid common investor pitfalls.

Professional analysts spend weeks building complex models and testing assumptions. But even a simple DCF model can help you figure out, for example, whether a company needs to grow 20% annually just to justify its current stock price—which might be a red flag.