Are U.S. Stocks Cheap? P/E ratios can make equities look cheap or pricey based on how they are calculated. How to make sense of this key question

THURSDAY, JANUARY 2, 2014

Are U.S. Stocks Cheap?

By JACK HOUGH | MORE ARTICLES BY AUTHOR

P/E ratios can make equities look cheap or pricey based on how they are calculated. How to make sense of this key question.

Based on the ratio of share prices to earnings, are U.S. stocks more expensive or cheaper than usual? That’s a simple but important question with a complicated answer. Last year, the Standard & Poor’s 500 index of large U.S. companies gained 30%, not counting dividends, its strongest result since 1997. Earnings for index members hit record highs, too. The index stands at 15.2 times forecasted operating earnings for 2014, according to S&P. (More on “operating” in a moment.) The average since 1988, when S&P began tallying operating earnings, is 18.7 times trailing earnings. That suggests that stocks could gain more than 20% in 2014 and still be reasonably priced. But there are three problems with that thinking.The first is that 2014 estimates look too optimistic. S&P’s numbers imply 13% growth, versus recent growth of just 5%. FactSet, another data source, uses a different earnings definition and so has different numbers, but the theme is the same: forecasts for 2014 look far too high.

The second problem is that S&P’s history on operating earnings only goes back to 1988, and covers a period that has been skewed by stratospheric valuations for dotcom companies and other factors. And a third, related problem is that the measure itself might be too generous.

Operating earnings are supposed to ignore one-time adjustments to earnings due to corporate restructurings and other events. But they give companies an incentive to treat ordinary costs as extraordinary ones, and steer investor attention to adjusted numbers. A study published last year in the Journal of Accounting and Economics found that companies are 20% more likely to meet or beat Wall Street’s forecasts when they incorporate special exclusions into their earnings math.

A more conservative approach to price-to-earnings math involves using an all-in measure of earnings (also tallied by S&P), and to focus on 2013 earnings, three-quarters of which has already been reported, rather than 2014, for which the numbers won’t start rolling in until springtime. A side benefit of that approach is that the history for all-in earnings is much longer. The S&P 500 stands at 17.4 times 2013 earnings. The average since 1935 is 16.9 times trailing earnings. That makes stock prices look full, but not bubbly.

Throw in two final factors. The first is that bonds, the chief rival to stocks for investor affection, had a lousy 2013, which has made yields more competitive. Over the past year, the 10-year Treasury yield has risen from well below 2% to over 3%. The dividend yield on the S&P 500, meanwhile, has slipped below 2%.

Second, corporate profit margins are unusually high. Historically, that has signaled that margins are about to fall, which would sap earnings and leave price-to-earnings ratios higher. This time around, factors like global outsourcing of labor and low corporate taxes may keep margins higher for longer. If not, stocks are likely too expensive. Based on a 10-year average of earnings, meant to smooth for swings in margins, U.S. stocks go for over 25 times trailing earnings, versus an average since 1935 of under 18 times, according to data compiled by Yale economist Robert Shiller.

All told, stock bargains are becoming harder to find. Investors searching for them in 2014 shouldn’t just look for share prices that are reasonable relative to earnings forecasts. They should also consider carefully whether Wall Street’s forecasts look reasonable, the company’s earnings look fairly stated and its profit margins look sustainable.