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No, The Markets are NOT Overvalued, and Here's Why!

Tuesday, January 26th, 2016

I'm sure you have heard it, and maybe even think it: “The stock market is over-valued, it’s too pricey; it is high and going to crash!”

Well let's step back for a minute and understand what the market is. I'm talking about the S&P 500, which are the 500 largest companies in the United States and represent corporate America.

First investors have to understand how the index is computed. As I said, it is based on 500 companies, what their stocks trade for and the company's earnings. It is known as a weighted index, which means your larger capitalize companies have more weight than your smaller capitalize companies.

The total market capitalization of the entire S&P 500 exceeds $18 trillion. The yearly earnings of these 500 companies exceed $800 billion. I think it is foolish when people say the stock market is overvalued, because the number is “such and such.” You can't know the value unless you know the earnings.

So don't base it on past numbers saying the index is too pricey at 2000, unless you know what the earnings were as well. I will tell you most people have no clue what the earning are. They simply base it on history and the number they hear.

It is important to look at what investors are paying for the index based on what is known as a PE (or price-to-earnings.) There are two types of PE's: trailing twelve months, which is based on what the companies have earned over the last 12 months; and what is known as a forward PE, which is based on the average earnings estimates of the analysts who follow the stock.

The normal forward PE goes out one to two years out. The forward PE will generally be lower than the trailing 12 months, because earnings generally increase going forward. A good ballpark average is somewhere between 14 and 17 times earnings.

Hopefully now you will never say the index (whether it be the Dow Jones Industrial Average or the S&P 500) feels too high simply based on the number. Understanding the numbers, I think the S&P 500 is actually undervalued based on earnings, and here's why:

Remember that it is a market capitalization weighted index. You may have heard of what is being called the fang stocks; these four stocks include Facebook, Amazon, Netflix and Google. The total market cap of just these four companies is about $1.6 trillion, which is nearly 10% of the entire index.

Facebook has a price earnings of 98 over the last 12 months, Amazon comes in at 854 times earnings, Netflix has a PE of 360, and GOOGLE (now called Alphabet) looks like a great value with a PE 30! (Not really, I'm just joking because the others have such high price earnings ratios.)

To put it in perspective, when we invest in a company for our portfolio and for our clients, we will not pay more than 12 times forward earnings for a company. With such high valuations and large market cap, these four stocks alone really bring up the PE ratio of the index.

There is also a high number of companies with price-earnings ratios above 40 times. There are actually 47 companies, which on a number basis makes up 10% of the companies. These are not small companies either, including Kimberly-Clark Corporation, Under Armor, Yahoo and Red Hat Inc.

This all reminds me of the tech boom when companies had extremely high valuation ratios, including the price-to-earnings ratio. I do not believe we are at that level yet, however there are too many companies that trade at such high price point ratios and have a substantially large market capitalization. 

So I guess as a whole, one could say yes, the stock market is overpriced based on what investors are paying for earnings in the index.  But looking underneath the numbers, one would find that there are some very good values in this market. However for those who hold the index or are buying or holding these high valuation companies that I mentioned earlier- I do believe they will be disappointed down the road as their stocks fall.

At that point in time the index will once again look reasonable to the talking heads on TV that only look at the one number and don’t understand what makes up that number. And hopefully, people understand that there are a lot of good companies trading at very good prices or valuations for the long-term investor.

Do you have a question or a company you would like us to take a look at?
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