Now might be a good time to buy.
That’s according to a recent analysis by Morningstar, which reported an apparent contradiction in stock prices. The market as a whole, writes Morningstar, is expensive. But those prices are a bargain compared to what the underlying companies would typically cost.
At the threshold level, stock prices have risen significantly over the past few years. As Morningstar writes, its U.S. market index is up about 8.6% in 2023 alone and 16.2% from its recent low last October. This is despite 2022 inflation, which has largely but not yet fully subsided, and lingering worries of a possible recession at the end of 2023.
“We still think the US stock market looks expensive and is getting more expensive year-to-date,” Morningstar wrote, quoting Jim Masturzo, chief investment officer of multi-asset strategies at Research Affiliates. “The market is holding up well given the macroeconomic environment.”
So where can investors find the best deals?
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For the best deals, look for value stocks
Look at the S&P 500 and you will also see high stock prices. From an October 2022 low around 3,500, the S&P 500 is now back to around 4,200 points. Even if you don’t view the March 2020 low as an outlier, it’s a huge gain from the S&P 500’s pre-Covid value of around 3,300 points.
The stock market is therefore doing well, with high prices that continue to rise. Much of that, writes Morningstar, is due to tech stocks which have seen huge gains in recent months and years. It is “big tech stocks that dominate weightings in major equity indices, like Apple (AAPL) – up 35% in 2023 – and Alphabet (GOOGL) – up 39% so far this year. That, some strategists say, has left big growth stocks particularly expensive.
Expensive is a word for it. As of this writing, Apple is trading for $177 and Alphabet for $123. Stocks like Tesla (TSLA) and Meta (META) were trading at $197 and $263 per share, respectively. Although, to be fair, none of these compare to Chipotle Mexican Grill (CMG), which currently has a stock price of $2,064.
Yet despite these high prices, Morningstar believes that now is still a good time to buy. “[B]y Morningstar’s fair value estimate measures that stocks are actually undervalued by more than 9%, with value stocks looking particularly cheap,” writes Morningstar. “This market discount, however, has narrowed significantly since the October low.”
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Key to this analysis is the term “value stocks”. Morningstar sees a market rich in value stocks.
Stocks are considered value stocks when they have a low stock price relative to the company’s underlying value. For example, if you look through the books of a company and decide that it is worth about $20 per share, but is currently trading at $15 per share, you would consider it a value stock.
Value stocks are generally considered a good buy for long-term investors. Historically, the market has been quite successful in correcting a company’s stock price to its fundamental value, a process known as “market efficiency”. Investors who buy a stock below the company’s fair valuation can generally expect the stock’s price to rise over time to the level of its fundamental value. (Some economists have criticized market efficiency theory in the era of soaring tech sector valuations.)
The tricky part is determining the underlying value of this business.
How to Analyze a Company’s Underlying Value for Cheap Stocks
Investors use a number of different metrics to decide what a company should trade on, including metrics such as volatility (lower volatility tends to mean higher value), dividends (higher dividends show flow higher cash flow) and the share price of peers/competitors (competitors with higher prices suggest a valuable industry). However, the most common metric investors look for is a company’s price-to-earnings ratio, or P/E ratio.
The AP/E ratio measures a company’s stock price relative to its total earnings per share. For example, suppose a company is trading at $40 per share. He issued 1 million shares in total and he made a total profit of $20 million last year, giving him a profit of $20 per share. The company’s P/E ratio would be 2 ($40/$20).
The price/earnings ratio indicates the value you get for every dollar invested in a given stock. In our case above, for example, you pay $2 in stock price for every $1 in company profit. Or, to put it another way, every $2 you invest in the business buys you $1 of value.
In general, across the entire market, 16 is considered an average price-to-earnings ratio. This means that with an average investment, you pay $16 for every $1 of underlying income. Companies with a low P/E ratio, whether relative to peer industries or the market as a whole, are generally considered value stocks. It is likely that other investors will drive up the price of this asset as it offers better value than comparable investments.
This all brings us back to Morningstar’s analysis.
As we noted above, Morningstar sees a market rich in value stocks. This is due to several different factors, including standard P/E ratios and an adjusted form of this analysis known as the cyclically-adjusted P/E ratio, or “CAPE”. A CAPE analysis uses a company’s inflation-adjusted earnings over the past 10 years, rather than the company’s most recent earnings report, to try to remove short-term anomalies from the business cycle. With both standard P/E analysis and CAPE analysis, Morningstar writes, “fair value suggests stocks are undervalued.”
“Up 8.6% year-to-date, the Morningstar US Market Index is posting a price-earnings multiple of 19.8x based on trailing 12-month earnings,” Morningstar writes. “This compares to a P/E of 24.2x at its peak in late 2021 and 17x at its low in mid-October 2022… [And] value stocks are cheap compared to growth stocks [with] the materials sector is trading at a P/E of 15 versus an average closer to 18. Energy stocks are trading at a P/E of 7 versus an average of 16.”
This is even true outside of the United States, where emerging markets trade at a P/E ratio of 13.5.
Now, it’s important to understand that investors should always look for value. Large-cap stocks, especially in technology, are expensive. “They are very high historically and relative to interest rates, liquidity and inflation,” notes Morningstar’s analysis. This means, in a nutshell, that tech stocks have most likely reached or exceeded their fundamental value. These companies have experienced strong growth, which means that there is not much of a gap between their stock prices and their value.
High-priced stocks that demand hundreds of dollars per share may grab headlines, but they don’t necessarily determine market value. Instead, look for stocks with strong trading fundamentals and a low P/E ratio.
Because despite the strength of the market, they are there, and now might be the perfect time to buy them.
The essential
Recent Morningstar analysis suggests now may be the right time to buy into the market. Even though the prices are high, they are often low relative to the underlying value of the companies as a whole, making this a high point for potential investors.
Fundamental investment advice
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The AP/E ratio is part of what is called “fundamental analysis”. This means that you examine the strengths and weaknesses of the underlying business to find good investment opportunities. It’s an essential part of any long-term investor’s toolbox.
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Looking for bargain stocks? Morningstar says these are cheap appeared first on the SmartAsset blog.