How to Value Stocks With the Market Near All-Time Highs

The S&P 500 has more than doubled over the past five years and sits within 3% of its all-time high as of this writing. In this video from Motley Fool Live, recorded on Sept. 9, Fool contributors Matthew Frankel and Jon Quast consider whether the market is too hot for investors to handle right now.

Both Matt and Jon agree that stocks need to be considered on an individual basis. Traditional valuation metrics can help, but each company has a specific context that helps investors understand whether it's overvalued or undervalued. 

Matt Frankel: Do you think the market is too expensive right now? It's probably the toughest question I'm going to ask you today.

Jon Quast: It is a tough question, Matt, and the reason I think it's tough is because there's two elements when you're valuing the market, when you're valuing individual stocks. On one hand, you have the pure math of it that's very objective. We're going to explain what the price-to-earnings metric is, what the price-to-sales metric is. These are easily calculated. They're simple math and it's very objective.

Yet, they're kind of useless because there's this whole other element that goes into it, that is context. The context is very subjective. But without the appropriate context, you really can't understand the valuation. There's the element of objectivity and subjectivity playing together, that makes it a very complicated question.

Frankel: One thing that I hear all too much, especially on Twitter from a lot of people is, valuation doesn't matter when you are talking about growth stocks. I usually end the conversation there. I consider myself to be probably the most value-oriented investor at the Fool, I'm definitely a value investor at heart. But the definition of valuation, it is different depending on what kind of stocks you are talking about.

With my investment style, I definitely consider valuation. Even the most growthy stocks, the goal of a growth stock is to eventually get to a point where you're making profits and you can be valued by traditional metrics. Apple started out as a money-losing growth stock. Now you can actually make the argument that it's somewhat of a value stock based on traditional metrics.

Valuation absolutely matters. No one's going to buy a growth company with a market cap of $1 trillion if there's no reason it could ever justify it.

How does valuation come into play in your investing style?

Quast: Matt, I think I'm similar to you in this aspect. Valuation does matter. It's constantly trying to find that appropriate context like we're talking about.

I'm going to share my screen real fast, if I can remember how. There it is. This is some research here from Yardeni Research. This is showing the P/E ratio of the S&P 500. I just wanted to put this up here just so people can get a glimpse. This is going all the way back to 1989. The blue line is trailing, the red line is forward. We're going explain what these mean. But for now, just suffice it to say that the higher the line, the more expensive, by a valuation metric.

You see this big spike here in the blue line is also up on the red line. If you're saying, yeah, by a P/E ratio, the market is historically expensive.

This is the price-to-sales ratio for the S&P 500. See it over here in 2006, way down under 1.5, we see it right now almost double that at 2.8.

On one hand, that would say that we are overvalued but there's context. The top five stocks make up a disproportionate size of the S&P 500 more than they ever have. That plays into it. Those are some quality businesses that deserve a higher valuation so they're dragging the whole market up. It plays a part of my investing style. But it's not the whole thing, so constantly trying to find that context.

I'll throw one example out there: Skillz. When that stock was up at $30, I really liked the business a lot. But to me, I forget what the market cap was at that time, but it looked very expensive based on where they were in their journey. When it got down to below $15, then it started to pique my interest based on the context, based on what their valuation metric was and their context or growth rate and all that, their opportunity. Yeah, I bought Skillz down there. I didn't want to buy it up there. It seemed like it was ahead of itself.

Frankel: According to your chart, this is the most expensive market we've seen since about the 2000, the dot-com bubble. I don't even really count that because that was a very sector-specific bubble. Most of the stock market wasn't trading at the valuations we're seeing today.

But another thing I want to point out is one big difference between this expensive market and previous ones: interest rates. Think of the interest rate environment today. I don't want to get into the mathematics of how interest rates affect the stock market. We don't have two hours for me to go on, drone on about that. I'm a former math professor talking about the interest rates.

But, interest rates are historically low right now. This means that investors can get a lot for risk-free assets. I don't know about you. I have no desire to own a 10-year treasury right now.

Quast: No. Absolutely not.

Frankel: Or put money in a savings account for that matter.

Quast: Yeah, you're not even keeping up with the rate of inflation with those.

Frankel: The risk premium has to be tacked onto stocks for the return potential is much greater than it was in either of those previous market booms that we saw.

With that, I don't want to drone on too far about interest rates, but that is one big difference in this market, that's worth pointing out. As Jon mentioned, we have to think about different stocks differently. I already mentioned the way I value Apple is different from the way I value my bank stocks. I'm a big bank stock investor like Bank of America is one of my big positions. That's very different from the way I evaluate growth stocks. Pinterest is my second biggest stock holding. If you try to use traditional valuation metrics, I would have to be crazy to invest in it. You have to think of it in a different context.