Expensive Or Not? A Study In Market Value Measures
By David Dierking
As the markets approach two years of gains, the question inevitably becomes where it heads from here. Can the market continue to manufacture meaningful and sustainable returns or has this been just another bear market bounce that will eventually lead us back to where we were before?
Both experts and individual investors like to use market value metrics to help answer this question. While they’re not a glimpse into the future they do give you an idea of whether or not the market at its current level can be considered cheap or expensive compared to historical levels. These measures tend to point you in the right direction as to where the market currently stands but as with all measures each one has its own strengths and weaknesses.
Here are a few of the ratios used most often.
This is easily the most widely used metric in the financial world. The P/E ratio measures a stock’s current price against its estimated next 12 months earnings. This is referred to as the forward P/E ratio. Other interpretations use the trailing 12 months earnings but the forward P/E ratio tends to be used more often. A ratio of around 15 would be the long-term historical average but the value can vary widely. During the dot-com bubble, P/E ratios climbed well over 40.
The PEG ratio takes a company’s P/E ratio and compares it to its estimated earnings growth rate. Companies with fast growing earnings sometimes warrant a higher P/E ratio. Stocks like these can look expensive looking just at the P/E ratio and the PEG ratio tries to determine whether or not a stock would be considered overvalued when taking its growth rate into account as well.
The dividend yield measures a company’s recent annual dividend against its current share price. This can be helpful if you’re looking for extra income in your portfolio but really needs to be examined closely. Smaller companies or companies with fast growing earnings tend not to pay a dividend at all (they’re generally reinvesting money in the business instead of handing it out to shareholders). Companies in distress that have seen their stock price drop can temporarily have very high dividend yields if an expected dividend cut hasn’t yet taken place. Proceed with caution when using this ratio.
Price to Book Ratio
This ratio tries to give you an idea if the company is properly valued in comparison to its intrinsic book value. This looks less at a company’s earnings flow and more at its actual value so you could end up being thrown off using this measure if the company’s earnings stream is less predictable.
The bottom line is that these ratios will never be perfect in telling you what the market is going to do. Stocks around the year 2000 looked very expensive yet kept going up until the bubble finally burst. Conversely, undervalued stocks or sectors can remain undervalued for a long period of time. These ratios are helpful though in managing the risk in your own portfolio. A balance of growth and value stocks can help limit the overall risk in your portfolio and understanding ratios such as the ones above can help you maintain that balance.
Photo credit: cavale
This article was originally written or modified on . If you enjoyed reading this post, please consider subscribing to my full RSS feed. Or you can also choose to have free daily updates delivered right to your inbox.