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Buying Stocks Now May Be Less Risky Than You Think


Investors like to use a gauge called price-earnings ratios in deciding whether to buy or sell. Low P/E ratios signal that stocks are cheap relative to a company's earnings; high ones signal they are expensive.

Right now P/Es are neither low nor high, suggesting stocks are reasonably priced

To calculate a P/E, you divide the price of a stock by its annual earnings per share. A company that earns $4 a share and has a $60 stock has a P/E of 15. Most investors calculate P/Es two ways: based on estimates of earnings the next 12 months and on earnings the past 12.

Stocks in the S&P 500 are at 13.7 times estimated earnings per share in 2013. That is close to the average estimated P/E ratio of 14.2 over the past ten years, according to FactSet. The P/E based on past earnings paints a similar picture. The S&P 500 trades now at 17.6 times earnings per share in 2012, basically the same as the 17.5 average since World War II, according to S&P Dow Jones Indices, which oversees the index.

Again, a caveat.

Another way to calculate P/Es, called a "cyclically adjusted" ratio, suggests stocks are not such a decent deal. Its champion is economist Robert Shiller of Yale University who warned about the dot-com and housing bubbles. He thinks it's misleading to look at just one year because earnings can surge or drop with the economic cycle. To smooth such distortions, he looks at annual earnings per share averaged over the prior 10 years.

The cyclically adjusted ratio is 23 times. Since the end of World War II, it's ranged between 6.6 and 44.2, and the average is 18.3. That suggests stocks are expensive, though perhaps not wildly so.

No matter which P/E you choose, it's important to think of it as a rough guide at best. Stocks can trade above or below their average P/Es for years.

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Chart of I:DJI
DOW 17,798.49 -14.90 -0.08%
S&P 500 2,090.11 +1.24 0.06%
NASDAQ 5,127.5250 +11.3820 0.22%

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