Why Stocks Aren't as Cheap as They Look

The first thing most investors learn about valuation is that a low P/E ratio means that a stock is cheap. But the next thing they learn is that buying a stock based on the P/E alone is fraught with potential disaster -- and if you don't understand what's behind both a stock's price and its most recent earnings, you're liable to make huge mistakes picking stocks.

Nothing beats a cheap investment
Recently, a report from Bespoke Investment Group said that stocks are cheaper than they've been since at least 1990. The report looked at a number of valuation measures, including ratios of price to earnings and price to book value, as well as dividend yields. In particular, the report pointed to several facts:

  • With an overall P/E for the S&P 500 of about 13 to start off 2012 compared to historical average price levels that typically weighed in around 15 times earnings, the stock market should be significantly higher. At just over two, price to book is also well under its historical average.

  • The dividend yield of the S&P 500 continues to beat the interest yield on the 10-year Treasury note. That's something that hasn't happened so consistently in more than 50 years.

The report concluded with targets between 1,410 and 1,491 for the S&P -- an advance of 7% to 13%.

But is it an illusion?
All too often, beginning investors focus solely on P/E ratios. The problem with them, though, is that they only reflect a snapshot of a moment in time. As such, they can give you completely misleading information.

For instance, take a look back at history to see some times when following P/E ratios would have gotten you in real trouble.

  • At the end of 2007, Citigroup (NYS: C) traded at less than eight times earnings. That was its lowest level in years, and a beginner looking at the stock might have concluded that it was extremely cheap. Similarly, AIG (NYS: AIG) saw its earnings multiple fall as low as nine, after having traded in the mid- to upper teens throughout the preceding years. Yet as we all know now, both of those stocks got hammered in the financial crisis, with earnings tumbling -- making it clear that investors were right and the P/E was wrong.

  • In cyclical industries, P/Es often get very low right before a downturn and very high before an upturn. For instance, during the commodities boom in 2007, refining stocksValero Energy (NYS: VLO) and Tesoro (NYS: TSO) sported extremely low earnings multiples despite posting strong stock price growth. Yet when the bottom fell out of the market, both stocks dropped precipitously and saw their earnings turn into losses.

Essentially, what happened in both these instances is that investors foresaw the coming drop in earnings before it actually came. If you hadn't been tracking the stock, you might have thought it was a bargain opportunity -- but in fact, it foreshadowed a coming drop in earnings. You can see the same phenomenon today with Devon Energy (NYS: DVN) , for which more than half of its earnings come from operations that the company has discontinued.

Are earnings vulnerable?
On a macroeconomic level, you can draw parallels between companies that seemed cheap a few years ago and the U.S. economy today. The economy has benefited from trillions of dollars in government spending and other forms of stimulus -- money that will eventually have to get taken out of the financial system. If the private economy takes up the slack, then the changeover could be seamless and smooth, and stocks would justifiably rally.

But it won't be an easy thing. Even as the labor market has struggled under the huge weight of unemployment, productivity gains have helped corporate profits. If political pressure forces employers to become less efficient, then those profits could fall sharply -- bringing the earnings side of the P/E equation down, and thereby putting downward pressure on stock valuations.

From an investing standpoint, you shouldn't rely on the entire market being cheap as an excuse to buy whatever you want. Instead, pinpoint companies that stand to gain no matter what the overall economy does. That way, you'll be in the best position to profit no matter what happens.

In the long run, though, your financial future depends on making smart long-term decisions. To invest accordingly, read The Motley Fool's latest special report, which highlights three stocks that will go the distance for retirement investors. It's free but only available for a limited time, so click here and read it today.

At the time thisarticle was published Fool contributor Dan Caplinger always doubts a bargain. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Citigroup and Devon Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy has the right price.

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