Five Stocks With Serious 'Catch-Upside'

Question: What is the current price-to-earnings ratio of the S&P 500?

Answer:

1. 16.3
2. 18.0
3. 19.8
4. All of the above

The correct answer is D. That's right, the S&P 500 trades for 16.3, 18.0 or 19.8 times estimated 2007 earnings. How can that be?

Well, there are four different ways to look at the S&P 500's P/E ratio. The most commonly used method sums up the market value and net income of all 500 companies and divides them. That gets us the 16.3 multiple on a $14 trillion market cap divided by $864 billion in estimated 2007 profits. But this calculation treats the index as one company. Do you view the S&P 500 as one company with 500 subsidiaries?

To get a fairer picture of the average P/E ratio of a 500-stock portfolio, which is what the index represents, one must calculate it differently than simply summing market caps and earnings. Plus, looking at the S&P 500 as a portfolio of stocks generates meaningfully higher valuations. With this methodology, the median P/E is 18.0, the mean P/E is 19.8, and the market-cap-weighted P/E is 18.0.

Clearly, the average stock in the S&P 500 is not trading at 16.3 times 2007 earnings. That 18 or 19 target advocated by most talking heads already exists, both in the S&P 500 as well as a broader index, the Value Line Arithmetic Index.

Digging a bit deeper, I calculated the valuations excluding the top 10 net income stocks. Everyone knows that a handful of big, cheap, ugly stocks such as General Electric (GE Quote), AIG (AIG Quote) and Exxon Mobil (XOM Quote) are pulling down valuations.

So I removed them and did the same calculations for the S&P 490. The mean and median levels did not change much, as one would expect. But the market-cap-weighted P/E rose to 19.0 times estimated 2007 earnings. Now that feels more like the stock market I know and love.

Click here for larger image.

I also calculated the profit margins for the index in the same manner as I did valuations. In every observation, profit margins are 15% to 20% above 10-year average levels. Since margins do mean-revert, it would not be unfair to normalize them lower to average levels. If you wanted to be a real pessimist, you could arguably contend that the S&P 500 trades for 25 times estimated, normalized profits.

So, despite what the talking heads maintain, the vast majority of stocks are already at high-teen P/E ratios. They might be "rationally expensive," as I have written in the past, but they are not cheap, 15-to-16 P/E stocks. Herein lies the silver lining.

Because the average stock is so expensive, fair valuation upside for an average company is much higher than most people realize. When investors revalue a cheap stock into average valuation territory, it doesn't have to stop at the S&P 500's 16 multiple. Rather, it can continue up to the high-teen P/E level, which is where the average stock resides today.