Saturday, May 7, 2011

Are stocks relatively cheap or expensive now?

Saturday, May 7, 2011








Q: What is the market's current price-to-earnings ratio, and does that indicate whether stocks are cheap or expensive right now?





  • The New York Stock Exchange is seen in the background of this Wall Street sign.

    By Timothy A. Clary, AFP/Getty Images


    The New York Stock Exchange is seen in the background of this Wall Street sign.



By Timothy A. Clary, AFP/Getty Images


The New York Stock Exchange is seen in the background of this Wall Street sign.






A: Knowing when the stock market is too hot, too cold, or just right takes a skill few investors possess. Given all the variables that knock stock values higher and lower and influence the economy and corporate earnings, knowing when stocks are overpriced is something investors routinely guess at, but rarely get right.


But that doesn't stop investors from trying. And one of the top tools investors use when trying to gauge if stocks are too expensive is the price-to-earnings ratio.This measure attempts to tell you how much other investors are paying for companies' earnings.


The higher the P-E ratio the more investors are paying for earnings and the more expensive stocks are. Likewise, the lower the P-E ratio is, the more cheap stocks are.


There are several ways to calculate P-E ratios. But for this discussion, we'll examine the P-E ratio based on the market's past 12 months of earnings for companies in the Standard & Poor's. As of the end of April, the S&P 500 was trading for 1364. That's the numerator of the P-E ratio. To get the denominator, you can add up the earnings of companies over the past 12 months, and arrive at $87.03 a share. Dividing the 1364 by 87.03 gives the S&P 500 a current P-E of 15.7 times.


The math is the easy part. The hard part is determining if the P-E of 15.7 indicates that the market is cheap, expensive or just right.


There are no hard and fast rules with this. One method is to look at a long-term average P-E and determine if the current P-E is relatively high or low.


Specifically, looking back at the S&P 500's P-E since 1988, investors find it has been 19.2, on average. Based on this, some investors figure that while stocks have risen dramatically since 2008, with a 15.7 times P-E, they're not necessarily overpriced relative to where they've been in the past.


The question, though, is whether or not the economy and earnings will continue to be as strong as they've been. Investors will demand strong results if they're going to continue to pay current prices or stocks, or even increase in the future.


Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies and Fundamental Analysis for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Follow Matt on Twitter at: twitter.com/mattkrantz





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