What is a â€œFairâ€ Price for Stock
Before you buy or invest in stock, you’ll want to answer the question: Are stocks valued appropriately for the current level of economic activity or expected level of activity over the next twelve months?
You can think about stock valuations a little like you might think about a house. When in the market for a new house, you quickly get to know the value of homes in a certain neighborhood. For example, if a well-kept, well-updated house is priced at $400,000, and a similar house is also priced at $400,000, but it needs significant remodeling, there is a good chance the second house is overvalued. A similar line of thinking can be applied to stocks.
One way investors compare stock valuations is a widely used measure called the price-to-earnings ratio, or P/E. This long used method connects the price of a stock (or a group of stocks) to the economic reality of the companyâ€™s financial position. The P/E ratio tells investors how much a share of stock costs per $1 worth of earnings.
For example, if XYZ stock has a P/E of 20x (read as twenty â€˜timesâ€™ earnings), that means investors are paying $20 for every $1 of earnings per share. If XYZ earns $4.00 per share, and the P/E is 20x, the price per share is $80. So, much like evaluating the relative value of two similar homes in the example above, investors can use P/E ratios as a method to discern attractive stock values.
Are Higher Valuations A Paradigm Shift?
Like the S&P 500 and the Dow Jones Industrial Average, the Wilshire 5000 is a diversified index of stocks. It was created in 1974 with about 5,000 companies.
What makes the Wilshire 5000 different from other well-known indices, is that it includes all US stocks with readily available prices. As of September 2020, the Wilshire 5000 index contains only about 3,400 stocks.
Since its inception in 1974, the number of US equities with readily available prices has declined considerably. Several factors including company bankruptcies, mergers and acquisitions, and public companies privatizing have contributed to the reduction.
Bottom line, the Wilshireâ€™s inclusion ofÂ allÂ US stocks illustrates how much smaller the breadth of the market has become over the past few decades. The lower number of stocks available for trading (lower supply) is likely one reason why company valuations are generally higher now than in past decades.