Recently, the CEOs of Netflix (NASDAQ: NFLX) and Tesla Motors (NASDAQ: TSLA) explicitly and publicly warned shareholders that their stocks look frothy. With price-to-forward earnings ratios of 102 and 170, respectively, that should hardly come as a surprise to investors. But what of the broad market? Even after a 23.5% year-to-date rise, the S&P 500 (SNPINDEX:^GSPC) trades at roughly 15 times estimated earnings per share for the next 12 months -- that hardly looks outrageous.
However, another valuation metric -- the Shiller P/E ratio, which uses an average inflation-adjusted earnings per share over a trailing 10-year period -- suggests the index is close to 50% overvalued by historical standards.
The Shiller P/E was popularized by Robert Shiller of Yale, who shared the Nobel Prize in Economics last month for showing that stock prices display some predictability over long periods of time, with valuation indicators (including the Shiller P/E) tending to fall when they are high, and increase when they are low. Right now, the Shiller P/E is roughly 50% above its long-term historical average.
In the following video, Motley Fool One analyst Morgan Housel and Fool contributor Alex Dumortier discuss how much weight investors ought to put on that metric in trying to answer a critical question: Are stocks overvalued?