I recently happened upon an article that I’d like to share with you. The article is from MarketWatch titled “The stock market is overvalued any way you look at it.” This article teaches us an important lesson about value.
Valuation in Fundamental Analysis
The first pillar of the 4 Pillars of Investing is fundamental analysis. One of the things we look at in the fundamental analysis is whether something is valuable or not. Another word for this is “valuation.” The author of the article is saying that the stock market is too expensive and people are putting more value on it than it merits.
We can identify the value of the market by looking at the price to earnings ratio (PE ratio). Essentially, the PE ratio tells us how much the customer is paying for their earnings. We determine the value by looking at price over earnings (Value = Price/Earnings)
Let’s take a look at a hypothetical example. GoPro has a product selling for $10 and Dell has a product selling for $5. Each company earns $1 from their products. The PE ratio for GoPro is 10/1, while Dell’s PE ratio is 5/1. Dell has a better value because the price to earnings ratio is smaller. They make more money off of a lower priced item.
Determining Value in the Stock Market
So what does this have to do with the stock market? We can determine the value of the entire stock market by looking at the PE ratio of all companies combined. If we are looking at the S&P, we would identify the price of buying every stock for all 500 companies, and then identify how much all of those stocks would earn in total.
The article looks several other measures of value in addition to the PE ratio. These include CAPE ratio, dividend yield, price/book ratio, price/sales ratio, and Q-ratio. Each of these indicators are part of the fundamental analysis.
To identify the market value over time, take a look at the market tops over the last 100 years and determine each of these indicators. Often, the market reaches a top right before people decide that the market is too expensive and they don’t want to put money into it anymore, which causes a crash.
Is Today’s Market Overvalued?
According to the article, “equities are more overvalued today than they’ve been between 69% and 89% of the past century’s bull-market tops.” Our market is getting high enough now that it is getting expensive to buy stocks. You can’t buy Apple stocks for $25 a share anymore. You can’t buy Chipotle for $10 a share anymore. We’re getting very close to where market tops over the last 100 years.
If we look at the Shiller PE ratio graph, we can identify times during the last century when the PE ratio has been higher than it is today. It was slightly higher in 2007 when the subprime meltdown began. It was significantly higher in the early 2000s during the dot-com bust.
The PE ratio at market tops might indicate that stock prices hover around 5 to 10 times the earnings. In the dot-com crash, the price of stocks was 200 times the earnings. Sometimes the ratio was infinite because companies hadn’t even started earning money yet. This is a helpful graph to understand where the bull-market tops have been historically.
The rising PE ratio of today’s market does not necessarily mean that there is going to be a crash. There are very few times throughout history when people have been willing to put so much money into stocks that pay so little, but it is not an absolute indicator of a market crash.
To read the MarketWatch article in full, click here.