Stock valuation: Has the recent rally made stocks too expensive?
Stock valuations determine how much you'll make when you invest in a stock. If you buy a stock when its valuation is high, you won't make as much (or lose money) over time. An article in the May 11th WSJ discussed stock valuations. They're not so attractive. The recent rally has seen to that:
"While the rebound was a relief for battered stock investors, it complicated matters for those still trying to decide whether to get in or add new holdings."
Now i'ts about a month later. Stocks aren't any more attractive. It brings up the question of what attractive valuations would look like.
At previous bear market lows (1982, 1974, 1949...) stocks had P/E (price/earnings) ratios below 10. They also had dividend yields of 6% or more.
But you might note that this past October P/E ratios were down around 11. Some investment advisors were touting the low P/E's as a buying opportunity. Were they wrong?
Yes, and here's why. The P/E ratio of 11 was based on "forward earnings." And forward earnings are calculated based upon analysts' estimates of future earnings. Therefore, if those estimates are wrong, the P/E is wrong.
Guess what? Those estimates were wrong. In fact, wildly optimistic. So the P/E of 11 was wrong.
What to do? Use "trailing earnings." Trailing earnings are based upon actual earnings over the last 12 months. No one's guessing or making up these numbers. The P/E's at previous bear market lows I cited above are based on trailing P/E's.
Lesson: whenver you hear talk of "P/E's" you must find out whether they are based on future earnings or trailing earnings.
There are other methods, such as five-year averaging of earnings. An argument can be made that that's an even better way to value stocks. But you'll do well with trailing earnings.
If you're doing things right and paying attention to stock valuations, don't get sucked into the "forward earnings" game. It's not always wrong, but it can be terribly wrong at times. And recent history is a good example of that. So use trailing earnings and value stocks accurately.
"While the rebound was a relief for battered stock investors, it complicated matters for those still trying to decide whether to get in or add new holdings."
Now i'ts about a month later. Stocks aren't any more attractive. It brings up the question of what attractive valuations would look like.
At previous bear market lows (1982, 1974, 1949...) stocks had P/E (price/earnings) ratios below 10. They also had dividend yields of 6% or more.
But you might note that this past October P/E ratios were down around 11. Some investment advisors were touting the low P/E's as a buying opportunity. Were they wrong?
Yes, and here's why. The P/E ratio of 11 was based on "forward earnings." And forward earnings are calculated based upon analysts' estimates of future earnings. Therefore, if those estimates are wrong, the P/E is wrong.
Guess what? Those estimates were wrong. In fact, wildly optimistic. So the P/E of 11 was wrong.
What to do? Use "trailing earnings." Trailing earnings are based upon actual earnings over the last 12 months. No one's guessing or making up these numbers. The P/E's at previous bear market lows I cited above are based on trailing P/E's.
Lesson: whenver you hear talk of "P/E's" you must find out whether they are based on future earnings or trailing earnings.
There are other methods, such as five-year averaging of earnings. An argument can be made that that's an even better way to value stocks. But you'll do well with trailing earnings.
If you're doing things right and paying attention to stock valuations, don't get sucked into the "forward earnings" game. It's not always wrong, but it can be terribly wrong at times. And recent history is a good example of that. So use trailing earnings and value stocks accurately.
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