Are You Paying Too Much for Your Stocks?

Last week, I took a look at stock market valuations as measured by Professor Robert Shiller's CAPE -- that is, the cyclically adjusted price-to-earnings ratio. Recapping in short, that measure seems to show that over the past decade-plus, valuations have been elevated well above their historical averages and seem due (overdue?) to for a period of lower valuations.

Frankly, I don't really like the idea that all stocks are overpriced right now, and a handful of my readers weren't keen on that idea either. I'm certainly not content with giving such an important issue a quick treatment, so let's dig in a bit further.

Brutal recessions
One commenter on my previous article, Sambar2pi, noted that the CAPE could be high right now because we've had multiple recessions over the past 10 years:

A high CAPE could mean current prices are historically high... but it could also mean earnings have been historically low, which wouldn't be surprising considering two (major) recessions have occurred in the past 10 years.

That's certainly true, but there are two reasons why I wouldn't be so quick to jump on this as a reason to dismiss the CAPE's cautionary result. The first reason is that the whole idea behind the CAPE is that it captures earnings over cycles so that it averages out the high earnings of the good times with the lower earnings of bad times. And while the more recent recession was unusually bad, the recession following the dotcom bust was actually a bit shallow by historical standards.

The second reason I'm wary about that logic is that if we hypothetically assume that instead of having a recession at the beginning of the millennium we had the peak earnings from 2000 extend through to 2004 and that the same thing happened with the more recent recession -- this time with 2007 peak earnings -- the CAPE falls drastically, but is still above the long-term average. That's not terribly comforting.

These stocks are deals!
Fool member daveandrae also weighed in on the discussion, stating:

Anytime you can purchase a small piece of a quality business like [Merck (NYSE: MRK  ) ] at less than 11 times its five year average earnings when ten year bond yields are less than 4%, equity investing makes sense.

In fact, there are a lot of stocks that look cheap right now, and that's part of the reason why I'm loath to say that all stocks are overpriced. But the problem is that part of the reason valuations look so tempting right now is because they've been so ridiculously overpriced over the past 10 years.

Coca-Cola at less than 20 times trailing earnings may seem reasonable, but that's largely because we were paying more than 24 times for it in 2007 and a whopping 71 times in 2000. And Cisco's (Nasdaq: CSCO  ) stock at 16 times earnings is blowing a lot of peoples' minds, but, again, that's partly because investors were valuing it at 26 times earnings in 2007 and 173 (!) times in 2000.

Other stocks look almost unquestionably cheap on an absolute basis. AT&T, for example, is trading at mere 8.7 times earnings while ConocoPhillips' stock fetches 9.5 times earnings. But if we rewind to 1982, when the CAPE was well below its long-term average at 7.4, both ExxonMobil and United Technologies' stocks could be had for 4.8 times earnings, while Coca-Cola was valued at less than nine times earnings. And those were the norms, not the exceptions, at the time.

Of course the interest rate environment was very different in 1982 than it is today, but I'd no sooner bet on interest rates staying as low as they are today than I'd quit my job to enter the NFL draft.

Stick with the cheap stocks
Even taking all that into consideration, I wouldn't call myself a bear right now. There are a number of factors that could continue to fuel investor bullishness -- regardless of valuations.

More importantly, the stocks that make up the market don't all carry the same valuations. So even though the overall market's valuation may not be especially appealing, we can still find stocks that have more attractive valuations. In a continued bull market, these lower-valued stocks would have upside potential as their valuation multiples caught up to the rest of the market, while in a falling market their already-low valuations would provide investors with some downside protection.

In keeping with the CAPE, I looked at the valuations of S&P 500 stocks in terms of average 10-year earnings as well as the more-oft-used one-year price-to-earnings ratio. Here are a few of the cheapest stocks in the index.

Company

10-Year P/E Ratio

1-Year P/E Ratio

Chubb (NYSE: CB  )

10.9

8.1

WellPoint (NYSE: WLP  )

11.7

8.7

Noble (NYSE: NE  )

13.6

12.4

Goldman Sachs (NYSE: GS  )

13.6

10.2

Forest Laboratories (NYSE: FRX  )

13.8

12.8

Source: Capital IQ, a Standard & Poor's company, and author's calculations. P/E=Price to earnings ratio.

A low valuation alone doesn't guarantee that a stock is a good investment. But these five could be a good starting point for finding stocks that are still attractive buys in today's market.

Have some of your own thoughts on what stocks are cheapest in this market? Head down to the comments section and sound off. Otherwise, you can check out five more stocks that my fellow Fool Morgan Housel thinks are worthwhile buys today.

Coca-Cola and WellPoint are Motley Fool Inside Value recommendations. Coca-Cola is a Motley Fool Income Investor recommendation. The Fool has created a bull call spread position on Cisco Systems. The Fool owns shares of Coca-Cola, ExxonMobil, and Noble. Motley Fool Alpha owns shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of AT&T, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (6) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 09, 2011, at 6:46 PM, TMFMMTInvestor wrote:

    "Frankly, I don't really like the idea that all stocks are overpriced right now, and a handful of my readers weren't keen on that idea either."

    Matt,

    Nice piece. I'd quibble a bit with your above statement, though, because it seems to me that the CAPE ratio is saying that the AVERAGE stock (which is what an index aggregates into) is expensive, not that ALL stocks are expensive.That's why a bearish fund manager like John Hussman who buys puts on various indices to hedge his carefully selected long positions can best be described as being long underpriced high-quality companies and short the average company (the index).

    Best,

    Scott

  • Report this Comment On February 09, 2011, at 7:16 PM, bsimps71 wrote:

    I would like to comment on this article married to dividend stocks- the hallmark of my investment strateogy. I love dividend paying stocks, but I don't want to pay too much. so, I analyze the PE vs the 5 year avg PE. If I were going to go out in the street and buy a business, the average price is going to be about 10 times earnings. That means the PE has to be about 10% less than the 5 year average PE on a dividend stock that my return is > 8%. that's about the general rule. So, the question is not only what the PE is but what price I'm willing to pay for that stock at the yield on my investment. If you take AT&T for example, yes the PE is lower than the 5 year average. but when the stock was $23/ share and still paying their dividend, it had a return of around 8% with a PE of less than 5%. that signals a buy for me because the yield is good and the price of the stock has room to grow. Not only am I earning a decent return on my investment, but I know the stock price is undervalued and over time it will grow above the 10% 5 year average PE. so, that's a total buy signal for me. and that's exactly what I did. when the stock price dipped down to $23, I bought. it's $27 now and climbing. I have nice returns on my dividend and the market value of my investment is over 20%. honestly, I don't give a crap what the price is because I'm still getting 8% from my dividend payments, but using PE, it was nice to know what price to buy at and to understand the stock was under valued at the time I bought.

  • Report this Comment On February 10, 2011, at 5:36 AM, daveandrae wrote:

    As i type, Best Buy sells for 11 times its five year average earnings, or yields roughly 9% to one's cost basis in earnings power.

    This compares to 3.76% for a ten year U.S. treasury bond and virtually 0% for cash.

    Thus, the best buy stock holder is accruing roughly 5.24% more, per year, in earnings power than the treasury buyer is accruing in interest income.

    Some of the 9% is paid out to the best buy investor in the form of a dividend. The undistributed balance is usually reinvested back into the business, via stock buybacks or outright acquisitions.

    Over a ten year holding period, the excess in stock earnings power over bond interest is sufficient enough to provide a real "margin of safety" which, under fairly normal conditions, will prevent or minimize loss.

    If such a margin is safety is present in a diversified group of, say, 10-12 stocks, then the probability of a favorable result becomes VERY LARGE. This is why you don't need a lot of insight or hindsight to be successful when it comes to buying common stocks.

    The danger to investors lies in purchasing stocks in the upper levels of the market, or, in buying speculative stocks with diminishing earnings power.

    Everything else, in my opinion, is "noise."

    The more complicated you try to make the investment process, the more disinterested I become. In my opinion, one will do appreciably better in the long run by simply asking the basic question "how much?'.

    Thomas Edmonds

  • Report this Comment On February 10, 2011, at 9:30 AM, manolosalceda wrote:

    I think there's a permanent disconnection between markets and the street. I don't understand why this is happening in such a constant way, but business's -small ones- are not improving the way the market has improved. So I see only a couple of outcomes: 1)either the street reaches market levels or 2)markets pull back from current levels.

    Now, I'm not usually a pessimist but I don't see real busines's reaching prebubble levels anytime soon, so valuations may be getting ahead of where they should be.

  • Report this Comment On February 10, 2011, at 10:04 AM, chaoticRick wrote:

    I'm a newbie, but... wouldn't a long term upward trend in CAPE mostly reflect an increased number of people and organizations wanting to own stocks over the alternatives? With the addition of lots of people (and cash) to the "investor class" due to IRA's, 401K's etc. and, the international growth of wealth looking for a place to invest, couldn't this ratchet up demand for equities faster than the earnings can grow?

    If there is a strong "demographic component" in long term demand for equities, what happens over the next decade as baby boomers move from growth oriented portfolios to fixed income?

  • Report this Comment On February 11, 2011, at 11:00 PM, TMFKopp wrote:

    @chaoticRick

    "wouldn't a long term upward trend in CAPE mostly reflect an increased number of people and organizations wanting to own stocks over the alternatives?"

    It very well could, and I address that here:

    http://www.fool.com/investing/general/2011/02/10/you-need-to...

    Matt

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