What is a meme stock?

A stock that observes a sudden increase in its trading volume due to hype on online and social media forums about it is known as a meme stock.

Due to the frenzied popularity created on platforms like Twitter and Reddit, most meme stocks become overvalued in a short span of time. AMC Entertainment, GameStop Corporation and Blackberry Limited are some examples of meme stocks that have trended widely in 2021.

A meme stock rally mostly involves struggling businesses; an unexpected increase in the stock price can offer plenty of opportunities for the management. Observing the rise in share price, companies can issue more shares to increase the liquidity, take up new projects, improve their operations, etc. 

What are the characteristics of a meme stock?

Some of the measurable characteristics of a meme stock are discussed below.

• Overvalued stock: As the narratives around the stock build, the demand for these stocks rises, leading to increased share prices. When compared to its competitors, these stocks are considered overvalued. Financial ratios or metrics can be used to identify if the stocks are overvalued. Some of the examples are:

• Price-to-Earnings Ratio (P/E Ratio): P/E ratio compares a company’s current stock price with its per-share earnings. If P/E ratio is high, it indicates that the stock is overvalued. Also, a higher P/E ratio means that its investors expect the company to grow in future.
• Price-to-Book Ratio (P/B Ratio): P/B ratio evaluates a company’s current stock price to its book price.
• Enterprise multiple (EV/EBITDA or EV multiple): Investors also use this multiple to verify if the company is undervalued or overvalued compared to its competitors or peers. A high EV multiple depicts the company is overvalued relative to its peers.

• Erratic price movements: It is said that a meme stock’s demand increases due to emotions and not because of rational analysis. Therefore, the prices are more volatile when compared to that of its competitor’s or non-meme stocks. Volatility can be measured using the standard deviation of stock prices for a given time.

• Demand among day traders: Retail investors communing in different online stock-oriented forums have been known to have an influence on meme stock rallies.

Frequently Asked Questions (FAQs)

1. How meme stocks gain popularity?

With trending discussions on online threads and internet virality, meme stocks gain popularity. However, the rapid price spikes are noted as hyped and not caused by the company’s performances or any particular update.

According to investors, the meme stock cycle involves:

• Early phase: When investors identify an undervalued stock and purchase the particular stock in large quantity. This bulk purchase increases the stock’s price.
• Middle phase: Active investors paying attention to the sudden increase in the stock purchase volume, buy the stock, fueling the stock price surge further.
• Late phase: Once word of mouth has spread significantly through social media and other online platforms, more retail investors step in and make significant investments.
• Profit-taking phase: After a few days of frenzied buying, investors from the early phase start cashing out their investments from the meme stocks with the fear of incurring losses. Thus, the price of the stock decreases.

In this cycle, early phase investors gain profits from investing in meme stocks because they have purchased at a lesser price when compared to investors purchasing in other phases. But it is said that once the meme stock rally has entered a phase where traders are fetching the stock due to a fear of missing out (FOMO), it is too late to earn profits.

2. What are some of the problems with meme stocks?

Investors should exercise extra caution while investing in meme stocks because they carry huge risk associated with them.

• The meme stock rally does not last: Once the excitement to purchase a meme stock wears off, the investments will also cool down. It is more of a guessing game for the investors if they buy the right stock at the right time. Online platforms like Reddit can come up with other meme stocks as well.

• Nothing can replace fundamental analysis: Investing in meme stocks is widely considered to be like gambling. It is advised that stock investments should be preceded by thorough analysis of the stock’s price chart and fundamentals. Meme stock investments more commonly involve following the trends on social media, which can put the investors in significant risk. Experts also often point that meme stock rallies are not always supported by the company’s financial performance and future growth perspectives.

3. What is a meme coin?

When a cryptocurrency is associated with a theme, often as a joke, it is referred to as a meme coin. Dogecoin, named after the Shibu Inu dog, is said to be the first meme coin. Some other examples of meme coins are jakememe70, pepememefrogree, etc.

There is little to no similarity between meme stocks and meme coins. Meme stocks are called so because of their unsustainable and frenzied rally. Meme coins, on the other hand, earn the title because they are usually developed on the back of viral social media memes.