The stock markets are trending higher, extending some recent gains and sparking the debate about whether stocks are cheap or expensive. With the markets difficult to predict and valuation swings from one extreme to another, it’s time for a refresher on some of the more traditional ways that stocks are valued. And not just if they are more or less than a latte at Starbucks.
The price-to-earnings ratio, commonly shortened to P/E Ratio or referred to as earning multiple, measures the share price of a stock against its annual earnings per share. If a stock trades at $10 a share and earns $2 a share, it has a P/E of 5.
Interest rates, or the cost of money, indirectly play a role in determining whether or not a P/E indicates a stock is a bargain or not, since Price to Earnings tend to decline when money is expensive and rise when it is cheaper. When interest rates are high, the value of future earnings takes a greater discount, meaning they are worth less.
The key element in a P/E ratio is the “earnings” portion. If earnings fall faster than the stock price, then stocks will look expensive even as share prices slump. Some P/E calculations use the prior 12 months – called trailing earnings – for E and others use the next 12 months – called forward earnings.
Today, on a trailing basis, the Dow Jones Industrial Average trades at a P/E of 14.77, which is barely higher than 14.53, the trailing P/E one year ago. So, stocks look like they’re priced a little higher than one year ago. On a forward-looking basis, the Dow’s P/E is 12.42 … even lower than it is today.
Historically, the average P/E has hovered around 15. That would mean that on a forward-looking basis, the Dow might seem a tad bit cheap, but, considering the last 12 months, it might still look expensive. Analysts continue to reduce their estimates of earnings, meaning that the E in P/E keeps falling. That means valuations won’t get greatly cheaper unless share prices drop even faster.
Dividend Yield Model
The dividend yield calculates the annual dividend payout as a percentage of the company’s share price. So, a company trading at $20 a share with a $2 dividend would have a dividend yield of 10%.
This valuation method indirectly measures profits (which are needed to pay a dividend) and the value of a dividend yield depends on interest rates. If super safe Treasurys are paying higher yields, then a company’s dividend yield becomes less attractive.
Dividends went out of style during the tech boom and dividend yields plunged. Today they are making a strong comeback. The dividend yield on the Dow Jones Industrial Average is 2.47%, compared with 2.30% a year ago. Given how low Treasury yields are (three year Treasury yields are around 0.39%), a dividend yield of more than that would indicate stocks are cheap.
But the dividend yield measure can also represent what’s called a “valuation trap” for investors. Yields rise as share prices drop. But, as we’ve seen among many companies in the past, falling share prices may be followed by the cutting or elimination of dividends as companies seek to preserve cash during hard economic times. So, while the dividend yield makes stocks look attractive now, dividends aren’t always stable and fully predictable.
The Dividend Discount Model
The dividend discount model is another way to use dividends to determine stock valuations. Dividends are an important valuation metric because they represent what a company pays to investors from its profits. Of course, some fast growing companies don’t pay dividends, which means the dividend-related valuation metrics aren’t universally applicable.
Basically, the dividend discount model uses estimates of future dividend payments and the time value of money to calculate whether or not a stock is cheap or expensive.
Recent reports indicate for the dividend discount model shows the stock market still undervalued. But similar to the dividend yield calculation, the risk to that calculation is the stability of dividends in the future, which is difficult to predict.
This valuation model seeks to measure the book value against its share price. The book value is the measure of the company’s assets as carried on its balance sheet, minus intangible assets and liabilities. In other words, if a company had to sell everything and pay off its debts, this is what the company thinks it would be worth.
Price-to-book was made popular by Benjamin Graham and is a valuation strategy used by Warren Buffett and other value investors. The current book value on the S&P 500 is estimated at around $608. With the S&P 500 closing at $1,400 (3/23/2009), that means the price-to-book ratio is about 2.3 (1400/608). That’s considered a historically higher level for book value and would indicate that stocks aren’t cheap (average P/BV since 1973 is 1.9).
So, are stocks cheap? It depends on the model, naturally. But most models indicate that stocks may be somewhat cheaper than one year ago. The question is whether or not they will get even cheaper still or continue to the recent rebound we’ve been seeing.