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The stock market is recording new highs nearly every day, while pushing its PE ratio to nearly double its average. To someone who may not know a whole lot about the market it could be daunting when you ask the simple question: is it too late to get in? Here is an article that can explain the simplest elements to look for in a stock before you invest.
For some background, the stock market currently has some expectations regarding tax cuts for corporations – warranted or not, that is to be determined. The United States has the third highest general top marginal corporate income tax rate in the world, at 38.92 percent (consisting of the 35% federal rate plus a combined state rate). If a company made $1,000.00 in a given period, their tax rate would be 35% or more, or in this case $350.00 leaving $650.00 in profits. Imagine more than a third of your bi-weekly salary gone to taxes – less to spend on groceries, entertainment and less to pay the bills. Because of the expectation to see tax cuts, the stock market is pricing in higher future earnings for companies, which means higher market valuations of the company’s stock.
How Do You Know When To Invest?
The best way to look at any stock is to compare it to a metric. This allows you to obtain a certain constant understanding of the value you extract throughout time. As we determined, the United States Dollar itself is not a constant, and thus fluctuates in value over time. One of the most common gauges available is the United States Government 10-year Bond rate (this is the interest rate that that US Government pays on its debts, similar to the interest rate that you may pay on your home mortgage). Currently, the yield on a government bond is 2.41%. With that yield, if you lent the U.S. government $1,000.00 they would pay $24.10 every year in interest. Then, after 10 years, the government would hand back your $1,000.00. Cumulatively, that would be $241.00 in interest payments to you that you would receive. That interest rate yield is low by historical standards. The average yield for the U.S. government 10-year is above 5%, double the current rate. That rate of 2.41% also just happens to be below the inflation rate of 2.5% as measured by the CPI. That means that after inflation, your investment is worth less than when you started. Price erosion diminished your buying power over the past 10 years, despite the interest earned of $241.
Nonetheless, that yield gives you a yardstick to compare any potential investment. Investors use the U.S. 10-year as the benchmark comparison because U.S. government debt is one of the most liquid instruments in the world, where you could easily buy and sell it. The US 10 Year Treasury is also considered one of the safest assets in the world, but history will decide that – we don’t necessarily agree with this.
Using the U.S. 10-year Treasury as a benchmark, you can then compare if what you are investing in is better or worse. Next, you need to look at what a company earns to determine how well the company compares versus the 10-year bond rate.
If you are interested in investing in a company then the thing you should be most concerned about is whether the company earns a profit or not. For that, one metric to look at is the earnings-per-share, EPS.
As Nasdaq.com states:
A company’s profit divided by its number of common outstanding shares. If a company earning $2 million in one year had 2 million common shares of stock outstanding, its EPS would be $1 per share. In calculating EPS, the company often uses a weighted average of shares outstanding over the reporting term.
The next thing you would examine is the Price to Earnings ratio (P/E Ratio):
The price-earnings ratio (P/E Ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
If a company is earning $1.00 per share and their stock is trading at $10.00, then their PE ratio is 10, or 10-times earnings. That PE ratio is what you are looking for when you want to compare a company’s earnings to the benchmark 10-year yield on government bonds.
If a company has a price of $10.00 and they have earnings of $1.00, giving them a PE ratio of 10, then the company is yielding 10% in a given year. You would invest your $10.00 to buy a share of the company and anticipate earning $1.00 in earnings, or, 1/10 = 10%.
Now that you have a way of looking at the PE ratio for a company, and you have the 10-year yield as the benchmark comparison, you can decide apples and oranges if the stock you are looking to purchase is the best opportunity around. Simply, you compare the expected yield of the 10-year treasury versus the expected yield you would receive in earnings by owning a stock.
Current Stock Market P/E Ratio:
On average, the stock market is priced around 15x earnings. If you purchased a stock with that P/E ratio you would receive about 6.67% return in a given year. That is above the current 10-year yield of 2.41%, but is still below average.
But, today’s stock market is priced very differently when compared to the historical average of 15. Right now the average of all stocks in the stock market is priced at almost 30-times PE. That is not the historical high however, it is relatively high compared to the past 135 years:
With a 29.37-times PE ratio you would be earning a 3.6% return in a year. That is fairly low, but is still higher than the current 10-year yield.
Buying future earnings
Keep in mind that a lot of participants are looking for the government to cut tax rates. If tax cuts happen then the amount earned by a company will increase from this, which may very well be already priced into valuations. Market participants are not purchasing stocks based on past company earnings, but based on the anticipated future earnings. That makes investing in the stock market potentially riskier than on average, despite the positive yield relative to treasuries. As valuations increase, so does the risk of witnessing a positive return on investment.
There is something cautionary in the chart above. There were only two times in the stock market’s history that PE ratio was as high as it is now. Those two times were the years 1929 and 2000. Both of those times the market sold off in what is now known as “Black Tuesday” of October 1929 and the Dot Com bubble of 2000. In both instances investors were purchasing stocks based on future earnings, which eventually became too optimistic.
If you think about it, the expectations of today’s stock market sound very similar to those historical peaks experienced over the past 100 years. No one really knows what it will look like or how long it will take to happen. Now it is time for reality to catch up to expectations, which is a much harder task to achieve. Personally, I am not invested in any of the cyclical industries at these valuations – perhaps it is now time to look for counter cyclical investments that move against the general direction of the market. After all, history has a tendency to repeat itself.