What Does Saying Stocks Are Cheap or Expensive Really Mean?
Setting Stock Values with Earnings per Share
As an investor in stocks, you want to make the best return on your investment (ROI) by buying or selling at the right time. You may hear financial media pundits say stocks or the shares of a company are currently cheap or expensive, but not really understand what they mean by those relative terms. You might often hear this type of terminology in connection with a story on whether now would be a good or bad time to buy or sell a specific holding.
The Meaning of Expensive
When experts call a stock expensive, they're often referring to a stock's price-to-earnings ratio (P/E). This metric tells you how much investors are willing to pay, in terms of a stock price, for the earnings a company produces.
In general, the higher the PE, the more expensive a stock's market value is relative to its value based on its financial performance, and the interest rates available on other investments. You can compute a stock's P/E by taking the current price per share and dividing it by the earnings per share (EPS). Use the following formula:
Price per share / Earnings per share = Price to Earnings ratio.
For example, a company with a $2 EPS and a current share price of $20 would have a P/E of 10. It tells you that investors are willing to pay ten times the EPS for the stock.
If a company's earnings remain constant, but the price per share continues to rise, this drives the P/E higher. At some point, analysts will deem the stock too expensive, which often precedes a recommendation to sell.
Conversely, as a stock's P/E falls, it will become cheap. In the fourth quarter of 2017, Warren Buffet commented that "measured against interest rates, stocks are on the cheap side compared to historical valuations." When a stock's considered cheap, this may turn it into a buy candidate. Of course, the stock's P/E is just one tool in evaluating stocks.
Interpreting the P/E
The cheap versus expensive analysis does not tell you an important detail. Investors need to know, at what P/E is the stock cheap or expensive? For individual stocks, start by looking at industry peers to compare their P/Es.
If other companies in the stock's sector show higher P/Es, then your candidate may indeed be cheap. Likewise, if the sector has lower P/Es, your stock may be expensive.
You can also look at the market overall to see if, in general, stocks are cheap or expensive. You can accomplish this by examining the P/E for the S&P 500 index, which many consider representative of the whole stock market. You can find current and historical information on the P/E of the S&P 500 online.
Interest Rates as a Driver
When deciding whether a stock is cheap or expensive, consider how interest rates on other investments work relative to stock values. As an investor, you might miss out on a better interest rate elsewhere by tying your money up in stocks.
Lower interest rates attract investors away from the bond markets, for example, and into stocks, which ultimately results in driving stock prices up due to the increased demand.
Conversely, higher interest rates elsewhere make stocks less attractive, and stocks must be priced low enough to entice investors into purchasing them.
These factors work independently of stock fundamentals that help drive stock prices, such as risk, growth prospects and profitability, and a stock's price will vary in different interest-rate environments, even if the fundamentals stay the same.