How to Value the Stock Market

Is the Stock Market Overvalued?

My opinion is yes. This post will explain how I came to this conclusion. Thanks to reader Bricks for bringing up this topic.

We’ll be looking at the S&P 500 because it’s a popular index and there’s a lot of data available for it. 🙂 This index basically represents a basket of 500 large publicly traded companies in the United States. We can analyze the following 7 metrics to determine how cheap or expensive the market is. And naturally each of these ratios below can be applied to individual stocks as well. 😉

1. Trailing P/E ratio
2. Forward P/E ratio
3. Forward P/S ratio
4. Price vs Forward Earnings
5. Shiller P/E Ratio
6. Operating Margins
7. EV / EBITDA ratio

Useful Ratios to Value the Stock Market

1) P/E Ratio – The price to earnings ratio, or sometimes known as the trailing P/E ratio or TTM P/E ratio, is a popular measurement to help determine the valuation of stocks. A low P/E ratio signals a cheap valuation. Historically the P/E ratio of stocks in both Canada and the U.S. hover between 10 to 20 most of the time. However, as of today the P/E ratio of the S&P 500 index is about 22, which signals it is overpriced relative to the norm. (image source)

2) Forward P/E Ratio – Unlike the trailing P/E ratio, the forward P/E ratio uses projected future earnings. Of course nobody knows how much money companies will make in the future, but this metric provides a sentiment of how profitable the market feels about the next few earnings seasons. According to a FactSet report, the forward P/E ratio of the stock market is 16.5, which is above the long-term average of 14.2. So based on this data stocks are currently about 16% more expensive than what they should be.

3) Forward P/S Ratio – The price to sales ratio compares the total market value to revenue. It usually moves in the same direction as the P/E ratio but can provide a smoother, more accurate depiction of the market’s valuation (see yellow line in chart above.) This ratio is currently over 1.6x for the S&P 500, which suggests the market is overpriced, even compared to 2008 levels.

4) Price Change vs Forward Earnings Change– The price of the stock market is mainly determined by its future profitability. But recently the price has diverged away from future expected earnings which suggests stock prices are too high.

Notice what happened after the last time price diverged higher from the forward expected EPS in 2006 and 2007. 🙁

According to John Butters, senior earnings analyst at FactSet, for the first quarter of 2016 it appears 92 companies have issued negative EPS (earnings per share) guidance and only 26 companies have issued positive EPS guidance. This depicts a rather bearish outlook. However, stock prices have not come down nearly enough to reflect these estimates. 😕

5) Shiller P/E Ratio – Also known as the P/E 10 Ratio, this ratio measures the price of the market to its average earnings from the past 10 years. Unlike the regular P/E ratio, the P/E 10 ratio is less prone to wild swings in any one year because it uses a 10 year moving average of earnings. 🙂 The market is currently trading slightly above 25x using this metric. This is abnormally high because over the last century there has only been 3 other times when the ratio has gone above 25x.

6) Operating Margins – When margins are squeezed companies will find it harder to increase profits since they are making less money on each unit of item or service sold. Combined with lower earnings forecast mentioned in point #4 above, a decreasing operating margin suggests companies should expect to see slower future growth.

7) EV / EBITDA ratio – The Enterprise Value (EV) is equal to: Market Cap + Total Debt + Preferred Stock + Minority Interest – Cash. The Enterprise Value to EBITDA ratio accounts for the market’s debt level. With so many corporations issuing debt to buy back stock or take over smaller companies, it’s important to keep an eye on their overall debt liabilities. Much like the P/E ratio, the higher the EV/EBITDA ratio, the more expensive the market is. Currently this ratio sits at 11.5x, which is quite high by historical standards.

These ratios outlined above are not perfect indicators by themselves, but together they paint a generally accurate picture of what’s happening in the markets now. The key takeaway is that the stock market is currently overvalued.

But that being said, I don’t plan to sell any of my stock holdings. Just because a market is overbought doesn’t mean it will correct soon. The housing market in Toronto has seen increased home prices for pretty much 20 years in a row and it’s still climbing, lol. It’s hard to explain why, but this picture says it all. ?

With higher than average valuations, and potentially disappointing earnings in the coming quarters, it’s easy to see why investors like myself are apprehensive about the stock market’s near future. I wouldn’t be surprised if we see a 10% or 20% pullback later this year. But of course, nothing is guaranteed. We should continue to plan our investments based on our risk tolerance and time horizon. 🙂

__________________________________
Random Useless Fact:

Most people cannot tell if this cat is going upstairs or downstairs.