How cheap are stocks now?
arren Buffet recently posted an optimistic letter to the New York Times, stating that American Stocks are currently being traded at very attractive prices. If you believe that the S&P500 represents the level of pricing of the US stock market, you’ll have to at least partly agree with Buffett since the current Price-to-Earning (P/E) of this index is more than 20% below its 100-year average value.
The P/E ratio is usually calculated as the stock price divided by some measure of the company’s annual earnings. Most analysts use last year’s Net Income for calculating the current value of the P/E and next year’s forecast earnings to calculate the forward P/E. However, history has shown that this measure is very volatile, and more troublesome, too optimistic. Therefore, it is preferable to calculate the P/E ratio based on the earnings of a longer period; usually it is averaged on the past 5-10 years.
At current heights, where the S&P500 index is traded around 900 points, the 5-year P/E ratio is around 12.5. Last time it went below 12.5 was more than 20 years ago, in late 1985. Over the past 137 years, the average 5-year P/E ratio stood on 15.6, more than 20% higher than the current P/E. The current average 10-year P/E is a bit higher, around 14.5, but it is still lower than its average (16.4).
This could be a sign that many stocks are traded at attractive levels. However, one has to keep in mind that the P/E ratio usually falls way below its average before the market starts to rebound. Moreover, if the market does go into a lengthy recession, it’s possible that the earnings of many companies will decrease dramatically, thus lowering their P/E in the future.
No one knows for sure if the stock market has already bottomed out, and many stocks could still fall further down in the near future; however, I think that most of them are traded at reasonable levels and are definitely not overpriced like they have been in the past. So, if you haven’t done it already, you should start digging the market, searching for great businesses that lost too much value and are currently being traded way below their intrinsic value.
1 comment October 26th, 2008
