How to Value Stocks

Earlier this month, the Dow Jones and S&P 500 both hit new all-time highs.
Many investors are thrilled to see their portfolio value growing month after month. But are the new highs a cause for celebration or concern?
More than anything, I’d say they’re cause for reflection.
To be sure, in nominal terms – current dollars – the market has reached a new high. But to focus on price alone is meaningless. Price must be juxtaposed to a specific variable to derive any value.
Earnings are usually the default variable. After all, earnings drive share price. Investors naturally begin their analysis with the price-to-earnings multiple.
Unfortunately, many investors improperly use the P/E multiple to value stocks. As I write, the S&P 500 trades at a 19 multiple on trailing-12-months earnings. That’s 3.5 points above the historical mean of 15.5.
By this simple S&P 500 P/E measure, stocks are only mildly overvalued. But there’s a problem with this simple P/E formula: it measures only trailing-12-month earnings.
During economic expansions, companies experience higher profit margins and earnings. The P/E ratio then becomes artificially low due to exceptional earnings growth. During recessions, profit margins and earnings shrink, which leads to artificially high P/E multiples.
But it can be misleading to look only at the trailing P/E ratio. No one would argue that early 2009 didn’t provided a perfect buying opportunity, yet many investors remained sidelined. They stayed away from stocks due to fear.
There is a better way to value the overall market.
The Shiller S&P 500 P/E multiple is purported to eliminate fluctuations caused by the variation in profit margins during the business cycle, which over the past 65 years has averaged three to five years from peak to peak.
During the last recession, the simple S&P 500 multiple hit an astounding 123-times earnings (not a typo). By then the S&P 500 had crashed more than 50% from its 2007 peak. The P/E was high because many companies saw profits shrink considerably.
Looking back, we know that 2009 provided a perfect buying opportunity for stocks. Yet the S&P’s P/E multiple of 123 P/E would have suggested otherwise.
The Shiller S&P 500 P/E, on the other hand, was at 13.5 in the second quarter of 2009, its lowest level in decades. And it multiple correctly indicated that this was a great time to buy stocks.
The real benefit of this valuation method is that it smoothes out earnings by using a moving average.
Today, the Shiller P/E multiple is at 24.6. Now this isn’t outrageously expensive. Yet it is a full 50% above the long-term average of 16.5.
That high valuation could indicate that future upside to the stock market is limited.
As I search for new investments for my own portfolio and to recommend to my readers, I’m finding it harder and harder to uncover real value investments. Part of the reason is that the market has become so extended.
While a simple P/E multiple makes the market appear reasonably priced, the Shiller P/E multiple suggests a richly prices stock market. I’d say the recent stock market highs are more cause for concern than celebration.

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