Toll Brothers (NYSE:TOL) released third-quarter earnings today, giving investors its current take on where the homebuilding cycle may be heading. Investors breathed a sigh of relief, bidding the shares up a couple of percentage points, but the shares still sit at less than half of their 52-week highs. The future's not so bright, either, but doesn't a current P/E of five factor in most of that downside?

I'll refer you to the company press release for all the juicy earnings details, but they'll do you little good; the environment going forward is not expected to bear much resemblance to the 13 straight years of record earnings that Toll just reported. Chairman and CEO Robert I. Toll explained the situation best in the press release: "The continuing malaise in the housing market, we believe, is the result of an oversupply of inventory and a decline in confidence: The speculative buyers of 2004 and 2005 are now sellers; builders that built speculative homes are trying to move them by offering large incentives and discounts; and some anxious buyers are canceling contracts for homes already being built."

Whether the weakness can be attributed to investors rather than homeowners has been a point of contention for analysts and investors alike, but there's no doubt that the market has started to deflate. The best investors can do right now is try to discern just how bad things might get before some level of equilibrium is reached again. CEO Toll offered his outlook: "With mortgage interest rates still relatively low, the economy basically sound, and household formations still increasing, we continue to believe that once the current oversupply of homes is absorbed and buyers become confident that home prices have stabilized, the market will return to firm footing."

To quantify that statement for Toll, it expects full-year 2006 earnings of $4.41-$4.63, down 6%-10% from a previous range provided. Based on a current price of $25.20, the new numbers represent a P/E of 5-6. The problem is, the way the industry is moving, the numbers could fall much further, and the main knock I have against homebuilders is that they tend to carry a fair amount of debt. In Toll's case, it's approximately 40% of total capital -- not overly high, but any extreme downturn could cause the interest burden to eat up a good amount of cash flow.

Another knock I have against Toll is that increases in inventory have eaten up most operating cash flow for at least the past three years, as is the case with most homebuilders. But inventory levels are decreasing fast, and as long as debt levels don't cause any liquidity issues during the downturn, the single-digit earnings multiples for Toll and other homebuilders prices in a decent amount of downside protection. For instance, if earnings plummet by 50% for Toll, or back to 2004 levels, then it's still trading at only 10-12 times.

There is definite uncertainty, but Toll may be one of the best choices in the industry. With the average price of its homes at about $700,000, it definitely serves the luxury homebuilding segment. This market is considered less sensitive to rising interest rates, energy costs, and economic uncertainty, thanks to supposed deeper pockets. If it's truly the speculative buyers who are causing Toll's current woes, then serving a more well-to-do client base may help it recover better than the competition. Additionally, the first wave of baby boomers just turned 60 years old and can reasonably be expected to drive demand for higher-end properties for at least the next decade.

In general, homebuilding stocks tend to trade in tandem with each other. Indeed, most of the individual stocks trade anywhere between 3-6 times trailing earnings. In essence, investors are getting paid to diversify, a topic explained by Bill Miller when I had the chance to talk with him in July. Thus, the best approach may be to invest in several names, since a recovery in homebuilding may lift the entire industry. That includes the larger names, such as Centex (NYSE:CTX), Lennar (NYSE:LEN), DR Horton (NYSE:DHI), and Pulte (NYSE:PHM). It's hard to say exactly how things will shake out, but as long as worst-case scenarios aren't reached, a contrarian viewpoint could prove lucrative.

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Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.