Various stock market indices have recently reached all-time highs. Should investors be concerned that the stock market is overvalued? Should investors be pulling money out of the market in anticipation of a correction?
Creighton University finance professor Robert Johnson, Ph.D., CFA, CAIA, says we can attempt to answer these questions by turning to the tenets of value investing – made famous by such investing icons as Columbia Professor Ben Graham and his most famous protégée, Warren Buffett.
“Value investing involves purchasing securities that are reasonably priced given their underlying fundamentals," says Johnson. “Ideally, for a stock to be a good value purchase, the shares in the company should be trading at a price that is less than the true value of the shares. Being a value investor is no different than seeking a value in the purchase of any good or service. As consumers, we generally prefer to buy things when they are selling at a discount and not when they are selling at a premium.”
Two common measures that value investors use to get an idea of how expensive or cheap a stock appears to be are price-to-earnings and price-to-book value. Johnson says these measures can be applied to the market as well as to individual stocks, and he adds, value investors prefer low values of these measures to high values. Low price-to-earnings and price-to-book ratios can signal potential undervaluation.
But low or high as compared to what? At any one point in time investors can compare these ratios across stocks.
“That is, comparing the ratio of one company to another. Value investors will prefer to buy stocks with low price-to-earnings and price-to-book ratios compared to other stocks,” says Johnson. “But, we can also use these measures to approximate how expensive or inexpensive the entire market is by comparing them over time.”
Using the S&P 500 as our standard, the price-to-earnings ratio of the market is around 19.4 today. This compares to an average price-to-earnings ratio of 27.4 over the past 15 years. "So, from this simple metric it would appear that the market may be undervalued,” says Johnson. “Before jumping to that conclusion, however, you should realize that price-to-earnings ratios were dramatically affected by the unprecedented financial crisis that began in 2008, so historical averages for the past few years are a bit skewed.”
At the height of the financial crisis, many firms’ earnings fell dramatically, causing price-to-earnings ratios to skyrocket. In fact, the price-to-earnings ratio of the S&P 500 temporarily topped 120 in May of 2009. According to Johnson, since 1871, the market price-to-earnings ratio has averaged around 15.5. So, from this simple analysis one could conclude that, while the market isn’t inexpensive, it also isn’t extremely overvalued.
A second measure value investors look at in attempting to identify potential investments is book value. Book value is an accounting measure that reflects the value of the assets the company holds net of any debts of the company. Because many assets are valued at historical cost it represents a very rough proxy of the net value of the assets of the firm. Currently, the price-to-book value ratio of the S&P 500 is around 2.70.
“To put this in historical perspective, over the past 15 years the average price-to-book ratio has been around 2.75. This ratio topped out at slightly over 5 in early 2000 and was below 1.8 at the height of the financial crisis of 2009. So, from a price-to-book value standpoint, the market appears to be moderately priced,” says Johnson.
By looking at both measures, Johnson says a value investor would likely conclude that the overall market is fairly valued relative to historical standards. However, valuations are forward looking and if an investor believes that prospects are good for further economic recovery, he or she will view these valuations favorably and be bullish on the market. But Johnson says, if on the other hand, an investor sees sluggish economic growth on the horizon and is concerned with the impact of the Fed tapering its stimulus, he or she would view the market as overvalued. Beauty is in the eye of the beholder – or stockholder – in this case.
Johnson is a professor of finance in the Heider College of Business at Creighton University, and is also a co-author of the book Strategic Value Investing (McGraw-Hill), 2014.