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Sober Thinking for the Stock Market Jitters

Monday, 25 Feb 2013 07:43 AM

By Sean Hyman

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Right now, investors are very jittery. Why? They hear about how the Standard & Poor’s 500 is at multi-year highs and how it’s near its two former peaks back in late-2000 and in 2008.

However, let me clear something up. It’s not just the stock market index’s level that it’s about, but what the companies look like this time around.

Well, one thing that I can tell you is that these 500 companies overall are generating a larger amount of earnings this time around … much different from the price of the index at the last two peaks.

For instance, in the peak in 2000, the S&P 500 was trading at a price-earnings ratio (P/E) of around 29 when it began to collapse. In the 2008 peak, the P/E was around 26. Again, in the same ballpark as the 2000 peak.

Are we anywhere near those levels this time around? The answer is no. The average P/E of the S&P 500 right now is around 17.

That’s honestly just over its historical average in the 14s to 15s. Stocks are still somewhat fairly valued here. So they’re not undervalued, but at this point, they’re not necessarily overvalued either.

Here’s the range. The S&P 500 will occasionally get as low as a P/E in the 6 to 8 range. That’s bargain territory for sure, but it’s always when people are scared out of their pants and afraid to invest too.

It’s one of the reasons why the average investor doesn’t make a “market beating” return. They buy back in once they’ve seen stocks rise again for quite some time. Well, by that time, stocks are back to their average P/E area of 14 to 15.

So when they start buying in when P/Es are average and they keep buying until the P/Es are high, no wonder they don’t have success.

When are P/Es considered high? Well, in looking back historically at the S&P 500, when the P/E gets into the 20 to 24 range, that’s when stocks are overvalued. Now, does this mean they have to begin falling then? No.

You’ll remember earlier that they didn’t fall in former times until the average P/E was around 26 to 29. You see, investors are very irrational at market tops. They’re willing to pay “top dollar” without knowing it because they’re caught up in the euphoria and they’re also convinced of prices going higher in the future because of what they’ve done for a good while in the past.

However, while that may be an “emotionally comfortable” way to invest, it’s not going to reap you big profits over time.

Keep in mind, you’re buying a slice of a company when you buy shares of a stock. This means you’re joining in as a beneficiary to that company’s earnings stream. However, if you overpay for even a great company, you’re not going to come out in the end.

That’s why judging a stock’s price (or index’s price) relative to its level of earnings is one crucial metric to tell if you’re overpaying for a stock or not. This is but just one of the several metrics I use in the Ultimate Wealth Report, but one of the more important ones for sure.

Imagine paying $600,000 for a business that puts out earnings of $100,000 a year. You’ve got a P/E there of 6. However, what if the company still put out $100,000 a year in earnings, but you paid $1.5 million for it. Then you have a P/E of 15. If you paid $2.3 million, then you’ve got a P/E of 23.

Imagine how long it would take to earn back your original investment if you paid 20 to 23 times its earnings capability? You’d be a long time getting back your original investment money.

However, if you paid six to eight times its earnings, then in just six to eight years, you’ve made back all of your original investment money and everything you earn from that point on for the next 20 or 30+ years in that business is almost like you’ve obtained a “free” earnings stream since all of your hard-earned capital has been recouped.

This is the way you want to think when buying stocks. You want to ask yourself, if you’d buy the entire company if you could and how much you’d be willing to pay for that company’s level of earnings.

The market, on average, through the years is willing to pay 14 to 15 times the earnings of America’s 500 largest corporations. The average investor is willing to buy-in at 14 to 20+ times earnings.

However, in the Ultimate Wealth Report, we buy companies “on the cheap” relative to their earnings power. We generally pay six to 11 times a company’s annual earnings. And even while we’re doing that, we’re usually reaping a dividend yield of 2.5 to 5 percent annually as well.

So if you’d like what I believe to be a safer, more methodical approach to investing, then come check out what we’re doing in the Ultimate Wealth Report

About the Author: Sean Hyman
Sean Hyman is a member of the Moneynews Financial Brain Trust. Click Here to read more of his articles. He is also the editor of Ultimate Wealth Report. Discover more by Clicking Here Now.

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