How Expensive Is The Stock Market Right Now?

You’ve probably seen analysts give buy or sell recommendations for certain stocks depending on whether or not they are cheap or expensive. But what does a cheap stock actually look like in comparison to an expensive one? There’s more to it than just looking at the price of one stock versus another.

A stock price indicates how much investors believe a company is worth. But a stock trading at $10 per share isn’t necessarily cheaper than a stock trading at $15 per share. Why? You have to incorporate a company’s earnings or how profitable it is in order to compare whether or not its stock is more expensive or cheaper than another.

A popular metric that investors look at when companies release their earnings announcements is the price-earnings ratio, commonly referred to as the P/E ratio, price multiple, earnings multiple or simply P/E. A stock’s P/E is calculated by taking its current price per share divided by its earnings per share (EPS). In essence, this metric indicates how much investors are willing to pay for the earnings a company produces.

Stocks with higher P/Es are typically viewed as expensive. While stocks with lower P/E ratios can be deemed as cheaper. That said, a savvy investor must compare the P/E ratio to the company’s growth rate. For example, if a company is set to grow earnings by 100 percent a year for the next five years, is trading at a 50X P/E multiple really expensive when compared to a company trading at only 20X P/E, but growing at a mere 5 percent a year? Stocks tend to be expensive for a reason. It’s when a P/E ratio looks low relative to the expected growth rate where an investor might find a buying opportunity.

Below is a sample illustration of why a stock trading at $10 per share isn’t necessarily cheaper than a stock trading at $15 per share when EPS is incorporated.

Stock A: $10 price per share / $1.25 earnings per share = P/E of 8
Stock B: $15 price per share / $2.5 earnings per share = P/E of 6

The calculated P/E ratios show stock B is cheaper – it has a lower P/E than Stock A – even though Stock B has a higher price per share. In other words, investors are willing to pay eight times the EPS for Stock A but only six times the EPS for stock B. If EPS for Stock B remains at $2.5, the price per share would have to rise to $20 for Stock B’s PE to equal that of Stock A.

It’s important to note there aren’t any specific thresholds that define when P/E levels are considered expensive or cheap. Thus, investors often compare a stock’s P/E to its competitors or specific industry when making trading decisions. As seen below, P/E ratios can vary quite a lot from one sector to the next.

P/E ratios can differ significantly by sector as seen in the sample table above. Source: Yahoo Finance

A solution for business cycle fluctuations and market swings

The downside of the traditional P/E ratio metric is most of the time it is only based on recent earnings and can fluctuate a lot due to variations of profit margins during business cycles. P/E can become artificially low during expansions when companies have high earnings and vise versa during recessions when earnings are low.

Differences between Shiller P/E and regular P/E by sector are shown above. Source: Gurufocus

Shiller P/E surpasses 27 for the first time since October 2007

In order to help avoid large swings in P/E, Yale University professor Robert Shiller created a normalized metric known as the P/E10 ratio, CAPE ratio or Shiller P/E. The Shiller P/E calculates the price to average earnings from the past 10 years, adjusted for inflation. This results in a normalized figure that is less prone to swings in any one year.

It’s worth noting that the Shiller P/E for the S&P 500 surpassed a level of 27 in August. Why is 27 significant? The Shiller P/E for the S&P 500 has only surpassed 27 consistently three times in history – at the beginning of the Great Depression, in 1997 leading up to the dot.com bubble and most recently at the start of the global financial crisis in October 2007. The fact that the S&P 500’s Shiller P/E broke above 27 in August doesn’t necessarily mean a bear market is right around the corner. After all, it took about three years following its appearance in 1997 for the tech bubble to burst. However, many investors are heeding its recent appearance as a warning to be cautious that an economic slowdown and disappointing earnings could be in store.

Other economic indicators have hinted there’s a possibility of a Crexit crisis and a likely chance the next U.S. president may face a recession, regardless of who gets elected in November. The current bull market that began in March 2009 is now the second-oldest in history and has already surpassed the post-World War II recovery from June 1949 to August 1956. The longest bull market to date was the rally in the 1990s that led up to the dot.com bubble. 

Another recent market anomaly occurred in August when the Dow, S&P 500 and NASDAQ all closed at record highs on the same day, not just once but twice within a week. The last time all three major indexes closed at all-time highs simultaneously was on December 31, 1999 at the peak of the tech bubble.

It’s impossible to know the future so these signals may not dictate a recession is imminent, but it’s becoming hard to ignore the possibility that market returns could start heading in a downward direction in the near term.

What can you do to prepare? Take time to thoroughly review your portfolio and see if it is inline with your long-term goals. It may be time to tweak your asset allocation if the stock rally has skewed your equity to debt ratio out of alignment. Learn more about the stock market and trading with our Investing Insights. Ready to get started? Open an account with Motif Investing today.

Investing in securities involves risks, you should be aware of prior to making an investment decision, including the possible loss of principal. An investment in individual stocks, or a collection of stocks focused on a particular theme or idea, such as a motif, may be subject to increased risk of price fluctuation over more diversified holdings due to adverse developments which can affect a particular industry or sector. Investments in ETFs can include those with a narrow or targeted investment strategy and can be subject to similar sector risks than more broadly diversified investments. Motif makes no representation regarding the suitability of a particular investment or investment strategy. You are responsible for all investment decisions you make including understanding the risks involved with your investment strategy.

Image credit: Flickr