A lot of questions come to mind regarding recent market action -- a slicing of about 1,000 points off the Dow Jones Industrial Average in the past three weeks, a similar percentage downdraft in the S&P 500, and an even bigger drop in the Russell 2000 small-cap index.

The mere decline of stock prices -- even if severe -- does not in and of itself make for a unique buying opportunity. Sure, stocks are cheaper today than they were a couple of weeks ago (to the tune of about 8%), but if they were particularly expensive to begin with, that doesn't make for any great opportunity today. Take a look at how stocks did after their first 8% drop in 2000, for instance. We need to look at some fixed points to know whether today's prices have any particular attraction.

Today, as with yesterday, and as with any other day you'd care to mention, the price-to-earnings ratio (P/E) of stocks is getting a lot of attention. Let's look at it.

The data
The P/E -- the price of stocks divided by their last 12 months of earnings -- is almost certainly the most famous and trusted single metric for valuing stocks. It isn't perfect (no single number could be), but there are plenty of studies demonstrating that buying individual stocks on the basis of a low P/E is a market-beating strategy.

It's interesting, to me at least, that in comparison to their previous 12-month earnings the stocks in the S&P 500 are cheaper as a group today than they have been for 12 years. Take a look at the relevant levels of the market over the past 12 years based upon second-quarter earnings:

Year

Q2-Ending S&P 500 P/E

Today

16.62

June 30, 2007 

17.34

June 30, 2006

17.05

June 30, 2005

18.80

June 30, 2004 

20.32

June 30, 2003

28.21

June 30, 2002

37.02

June 30, 2001

33.28

June 30, 2000

28.02

June 30, 1999

33.46

June 30, 1998 

29.10

June 30, 1997

21.83

June 30, 1996

19.21

June 30, 1995

15.82

First, it should be noted that the very high P/Es you can see for the years 1999-2003 are not universally poor times to have invested money into the market. The middle of 2002, when companies' earnings were extremely and temporarily depressed, was not a bad time to be putting money into the market.

Mid-2003, when the large caps in the S&P 500 had a trailing P/E of 28, was actually a pretty good time to be making investments -- again because the earnings in the denominator were so depressed that the ratio was misleading without taking normalized earnings levels into account.

So today's low prices for a dollar of the past year's earnings could be an indicator that it is an especially good time to invest new funds in the market.

But let's check out two arguments that are being raised against placing irrational exuberance on today's relatively low P/E. If today's earnings levels are not sustainable, stock prices aren't attractive simply on the basis of their ratio to earnings.

1. Net profit margins as a percentage of GDP.
Many investors and market observers have pointed out that profit margins for companies are at levels not seen for more than 50 years. The profit margins of companies are historically between 5.5% and 7.5%, though lately, profit margins have been above 8.5%.

Assuming that there is a reversion to the mean in profit margins, even if company revenues remain at today's levels, a drop merely to the upper end of the historical range would decrease earnings by 12%, and the P/E would then either adjust upward or prices would move downward -- or both.

Let's examine a few of the S&P's larger components to see how their net profit margins look today:

2003

2004

2005

2006

TTM

Coca-Cola (NYSE:KO)

20.8

22.3

21.1

21.1

20.0

General Motors (NYSE:GM)

2.1

1.4

(5.4)

(1.0)

0.9

Yahoo! (NASDAQ:YHOO)

14.6

23.5

36.1

11.7

11.0

General Electric (NYSE:GE)

13.9

12.9

11.5

13.0

12.8

United Parcel Service

8.7

9.1

9.1

8.8

8.5

Schering-Plough (NYSE:SGP)

(1.1)

(11.4)

2.8

10.8

14.2

As the table shows, net profit margins can move dramatically on a company-by-company basis. Also, buying and selling established businesses on the basis of a temporary spike or decline in profit margins can be worth your while. Getting out of Yahoo! in 2005 would have worked out pretty well. The same goes for folks who picked up shares of General Motors after its disastrous 2005.

Today's S&P 500 profit margins are probably not indefinitely sustainable -- even given the significant productivity improvements across the economy. At the very least, investors cannot expect further improvements in profit margins to mirror the improvements over the past five years.

2. Contribution from energy and financials.
A second argument frequently voiced against putting too much reliance in today's S&P 500 P/E level is that if you subtract the financial and energy companies from the totals -- two sectors that show particularly low P/Es, coupled with high earnings -- the P/E for the rest of the companies in the S&P 500 moves up significantly.

It is true that an energy company such as ExxonMobil (NYSE:XOM) has a P/E of 12, and Citigroup (NYSE:C) trades for 11 times its earnings. And with the ongoing and justified concerns about subprime lending and the effects on earnings that have yet to be revealed, we could see earnings for financials moving down instead of up over the next few quarters.

Anybody who wishes to forecast the profits of energy companies over the short term is welcome to try, but such profits are cyclical, and at peaks shouldn't be accorded high P/Es.

Still, excluding the best performers from a group and declaring that the rest of the group isn't priced quite as cheap is always going to be true. I don't put that much faith into this attack on today's lower P/E levels.

Shift your focus
It's well worth noting that today's large-cap P/E levels are more attractive than they have been for years, and that there are reasons why the simple bottom line doesn't tell the whole story.

It's also worth noting that Wharton professor, best-selling author, and leading market historian Jeremy Siegel has said that given the low trading costs and ease of diversification today, P/E levels of around 20 are probably justified for the future. If that turns out to be the case, today's levels are certainly one of the better buying opportunities you'll find.

But at The Motley Fool, we've always been far more focused on individual companies than the stock market as a whole. That's helped our leading newsletter, Stock Advisor, turn in stock recommendations that have produced 66% returns over its five-year history vs. 28% returns for the S&P 500.

A lot of that history has been dominated by times when the market looked far less tempting for large-cap stocks than today. If you take us up on a free 30-day trial offer, you can see the entire service and find out what companies our advisors like best right now.

Bill Barker does not own shares of any company mentioned. Yahoo! is a Stock Advisor recommendation. Coca-Cola is an Inside Value recommendation. UPS is an Income Investor pick. The Fool has a disclosure policy.