Econ Stories from two very creative people at George Mason University
Additional resources here about John Maynard Keynes and F. A. Hayek.
Thanks to NPR and The Corner at National Review Online.
The price/earnings ratio (P/E, PE) by itself has limited use. It merely indicates investors’ demand for the stock. The greater the demand, the higher the P/E because the stock’s price has been driven up by investor buying. Think of the P/E as a popularity indicator.
How to use P/E
By comparing a stock’s P/E with other P/Es, investors can determine whether a stock is over-, under-, or fairly priced. Compare a stock’s P/E with the following:
1. the P/E of the S&P 500 Index
2. the P/E of the company’s industry
3. the P/Es of the company’s close competitors
4. the stock’s 10-year average P/E
Comparing P/Es
1. Compare the Stock’s P/E with the P/E of the S&P 500 Index to determine whether the stock is fairly priced compared with the overall market. Currently, Home Depot’s (HD) P/E is 20.85 and the P/E of the market—the S&P 500 Index P/E—is 19.84. At this time, Home Depot’s stock is fairly priced (within 1½ to 2 points) compared with the overall market.
Home Depot’s P/E: http://finance.yahoo.com/q?s=HD
S&P 500 Index P/E: http://www.multpl.com/
2. Compare the Stock’s P/E with the P/E of Its Industry. P/Es are industry specific. Each industry has its own average P/E. Industries move in and out of favor with investors depending on the economy.
Begin by determining whether the industry is currently in or out of favor with investors. Compare the industry’s P/E with the market’s P/E. The Home Improvement Stores industry has a P/E of 19.80. This is in line with the overall market. On the other hand, the Broadcasting-TV industry (P/E of 0.60) and the Steel and Iron industry (P/E of 12.20) are out of favor. At this time, few investors are buying broadcasting-TV and steel and iron stocks because they feel companies in these industries will have difficulty maintaining their profitability in the current economy.
Industry P/E: http://biz.yahoo.com/p/industries.html For Home Depot’s industry P/E, scroll down to Home Improvement Stores.
Next, compare the stock’s P/E with its industry’s P/E. Home Depot has a P/E of 20.85 and the Home Improvement Stores industry has a P/E of 19.80. Home Depot’s stock is fairly priced compared with its industry. Investors feel that Home Depot will be able to grow its earning as well as the companies in the industry as a whole.
3. Compare the Stock’s P/E with the P/Es of Its Close Competitors. Home Depot has a P/E of 20.85, Lowe’s a P/E of 18.86, and Lumber Liquidators a P/E of 24.27. Investors expect Lumber Liquidators’ earnings to grow faster than either Home Depot’s or Lowe’s earnings. Home Depot is fairly priced when compared with Lowe’s and slightly underpriced compared with Lumber Liquidators.
Competitor P/Es: http://biz.yahoo.com/p/industries.html Scroll down and click on Home Improvement Stores to find a list of Home Depot’s competitors. (see the above Industry P/E insert)
4. Compare the Stock’s Current PE with the Stock’s 10-Year Average P/E. This comparison tells you whether the stock is fairly priced compared with the company’s past performance. Home Depot’s P/E over the past 10 years has ranged from a high or 42.9 to a low of 10.7. Its 10-year average P/E is 21.19. Home Depot’s stock is fairly priced compared with its 10-year performance—20.85 vs. 21.19.
Stock’s 10-Year Historical P/Es: http://quicktake.morningstar.com/StockNet/Valuation10.aspx?Country=USA&Symbol=HD You will need to calculate the 10-year average P/E.
Is Home Depot’s Stock Overpriced
Currently, Home Depot’s stock is fairly priced when compared with the P/E of the S&P 500—the market (20.85 vs. 19.84), fairly priced when compared with its industry P/E (20.85 vs. 19.80), fairly priced when compared with one of its competitors’ P/Es and slightly underpriced when compared with the other’s P/E (20.85 vs. 18.86 and 24.27), and fairly priced when compared with its 10-year average P/E (20.85 vs. 21.19). Therefore, based on P/E comparisons, Home Depot’s stock is fairly priced.
In Conclusion
To determine whether a stock is over-, under-, or fairly priced, compare the stock’s P/E with the P/E of the market and the industry, the P/Es of its major competitors, and with its own 10-year average P/E.
Try It
Determine whether a stock of your choice or one of the following companies is fairly priced: Nordstrom’s (JWN), Alaska Airlines (ALK), or Johnson and Johnson (JNJ).
Step-by-Step
1. Determine the stock’s P/E by going to http://finance.yahoo.com/q?s=HD. Enter your stock’s ticker symbol.
• The stock’s P/E is ___________.
2. Determine the P/E of the S&P 500 Index (the overall market) by going to http://www.multpl.com/.
• Compared with the market, the stock is over-, under-, or fairly priced: ________
3. Determine the P/E of the company’s industry by going to http://biz.yahoo.com/p/industries.html.
• Compared with the company’s industry, the stock is over-, under-, or fairly priced: __________________
4. Determine the P/E of the company’s competitors by going to http://biz.yahoo.com/p/industries.html and clicking on the company’s industry to see the company’s competitors and their P/Es.
• Compared with the company’s closest competitors, the stock is over-, under-, or fairly priced: __________________
5. Determine the stock’s 10-year average P/E by going to http://quicktake.morningstar.com/StockNet/Valuation10.aspx?Country=USA&Symbol=HD and entering your stock’s symbol. Calculate your stock’s 10-year average P/E by adding the 10 values and dividing by 10.
• Compared with the company’s 10-year average P/E, the stock is over-, under-, or fairly priced: _______________
Your Conclusion: Considering the above P/E comparisons, the stock is over-, under-, or fairly priced: ____________.
Looking Ahead
In the next article I will discuss answers to the following two questions: Why do some stocks have P/Es that are 30, 40, or more points above the market P/E? If a stock’s P/E is 8 or more points below the market’s P/E, does the low P/E indicate the stock is a true bargain, or does is signify the company is unhealthy?
The DOW down 213.27 points today. 
Citigroup and Bank of America down 6% and JPMorgan down 7%.
Fortunately, I’m mostly out of the Market right now—sold before the end of the year and have been busy getting ready to teach my Mutual Funds class.
On the other hand, the stock (VSEC) that I purchased on Tuesday to activate my Stock Market Game portfolio is mostly intact.
The story began with a small lake of money that became an enormous reservoir looking for a place to flow. In 2000 the lake held 36 trillion dollars. 
By 2006 the lake had become a reservoir containing 70 trillion dollars looking for a place to flow. 
The pool of money comes from savers around the world. It comes from you and me, from the people and companies in India and China who have been manufacturing the goods we buy—they made a lot of money, banked it, and saved it. It comes from all the oil producing countries, from individuals in France, Brazil, Russia, Ireland, England, South Africa, etc. It comes from premiums insurance companies charge and save until they need them for a catastrophe, from pension funds that are waiting for people to retire and start drawing their retirement checks, and from central banks that save for all the reasons they save.
In 2010 this is money looking for a place to be invested. True some of it was lost in the market, but others have made money in the current market. It is out there looking for an investment vehicle that will provide a return on the investment. New vehicles, new versions of Mortgaged Backed Securities, will be invented.
Read Clusterstock’s updated explanation of this phenomenon in the commentary on the above graph: It’s Going to be Brutal Putting the Banking Genie Back in the Bottle.
The panic/reality hit home on Monday that next Tuesday and Thursday evenings and all day Saturday I am responsible for 15 hours of lecture, demo, and supervised hands-on mutual fund analysis. However, by now the handouts are ready to go to the printer and I have a last welcome email to compose and mail to all participants. Here is the class description.
The Stock Market Game (SMG) is open for teacher and adult registration and for student investing. I’ve been doing a lot of SMG marketing to teachers the last few days. It seems to be paying off a bit. You are welcome to join us.
I have been watching football today and picking some stocks for my portfolio (SMG). I hope my stock picks are more successful than my team picks have been today. However, I can’t even find my Happy Bull Market graphic–that has to be a bad sign.
I’ve been writing most of the day on the second installment of Using P/Es (to determine if a stock is over-priced). How good it is to be back! Finally, I have my voice and format going. The voice is the same as Stock Market Investing Made E-Z, but the format is a bit different thanks to a comment from Dr. Frank I. Luntz in What Americans Really Want . . . Really. His comment went something like this—We want just what we want to fill our knowledge bank, when we what it—(I couldn’t find the actual quote again). That told me I needed to shorten what I wrote—smaller bites with bullet points, etc. The other day I bought WordPress 24 Hour Trainer by George Plumley. When I started using his book then reading it, I realized it had the kind of up-to-date format and style I was trying to come up with. He hit it right on—short chapters, bullet points, and lots of graphics. It’s nice to be “at it again” and writing—it’s been a year and a half since I finished work on the combined, updated, edited, etc. Slingerland text book and it went off to the publishers.
From time to time, I’ve suggested to my family that we should observe December 25th only as a religious holiday, the birth of Christ, and reserve our gift giving for January 6th, Three Kings’ Day, when the Three Wisemen brought gold, frankincense and myrrh. I’ve even offered the further enticement of celebrating the 12 Days of Christmas (beginning the 25th and ending January 6th) ala Hanukkah style—a gift a day. I have made no progress what ever!