Jim Cramer: Here’s How to Decide if Stocks Are Overpriced

NEW YORK (Real Money) -- Is the market too expensive? Are things overpriced? Is that what should jar us into the reality that we are on thin ice as we head charge into this notoriously ugly month where big capitalization stocks have historically been weak? Are we just whistling past the graveyard with Monday's gain?

First, let's break this concept down and then see if it adds any value to the investment process.

We try to figure out the value of stocks by looking at what we will pay, that is the price to earnings multiple for the collective earnings of the S&P 500. Right now it's about 18.5, which is a little high versus historical norms.

But what are historical norms really worth? For example, I have seen the market trade at 29 times earnings, a huge red flag that not coincidentally was where it was priced right before the crash of 1987.

I have seen it trade at 12 to 13 times earnings but that was typically when we had a lot of inflation or when we expected earnings were going to go down, not up.

So we can't look at it in a vacuum. For example, we know that we need to consider the relative worth of stocks as a whole to bonds. When I look at what I can get from the 10-year Treasury, about 2%, I have to find stocks, even with more risk, more attractive than bonds. So it stands to reason that the price-to-earnings multiple is elevated. Everything's relative. Stocks may not be a bargain but bonds are downright expensive, so I discount the 18.5x earnings issue as the cost of having such crummy competition from bonds.

Although, the entire construct of "the market" is something I balk at entirely.

The market is made up of pieces of paper that involve the ownership of different companies, and while there are some expensive stocks out there, we've got plenty of cheap ones, too, and others that are just plain in flux.

Let's deal with a couple. Today, on Twitter @JimCramer, someone was offering me "own, don't trade Apple  (AAPL)" t-shirts and it brought a smile to my face. Someone's listening.

Now, why do I reach such a charitable verdict? Is it because I like my iPhone so much that it is inseparable from me? Is it because I like my watch so much that I have ordered four of them for friends? Is it because I think Apple pay will become the de facto payment system for worldwide retail? Is it because I want to curry favor with CEO Tim Cook because he called in to our tenth anniversary show as "Tim from California"?

No, actually, it is because of the valuation. Apple sells at 14 times earnings, well below the average stock as represented by the S&P 500. It has the biggest buyback in history and yields the same as you would get from the five-year Treasury.

If you back out the cash, the darned stock is selling at 12 times earnings. I have searched far and wide for stocks that have the potential to have a double-digit growth rate that sells at only two-thirds the market multiple. That's just not supposed to happen, but it is and it is to a $750 billion company. It is one thing when, like in the year 2000, the biggest companies were selling at 80 and 90 times earnings.

It is quite another when the largest company is selling at a fraction of the market multiple.

Or how about the drug companies.

We know the big pharma companies sell at multiples that are a discount to the average stock because are growth challenged. But how about Gilead (GILD)? It has the number one growth franchise in the world, a cure for hepatitis B. What does this company, with the best balance sheet and an amazing pipeline with tons of possibilities sell for? How about 10 times next year's earnings. I think that's ridiculously cheap.

Okay, you think Apple and Gilead may be aberrations? The financials are the largest part of the S&P. So what's the largest domestic bank selling at? How about Wells Fargo  (WFC) at 13 times earnings. How about the largest international bank? JPMorgan Chase  (JPM) at 10 times earnings. How about the biggest brokerage? Goldman Sachs  (GS) at 10 times earnings.

If we are really on the precipice, if things are so dramatically overvalued, how do you get those miserly price-to-earnings multiples? Frankly, after all of the balance sheet improvement and all of the market share gains and all of the opportunity vs. what they had just seven years ago, how can these stocks be valued so low!

Or how about the airlines.

Last week, I spoke to Gary Kelly, the terrific CEO from Southwest Airlines  (LUV) and the cream of the crop airline on Mad Money. His company had widely been perceived to want to grow capacity by 8%, something that caused tremendous pain in the group, particularly when the CEO of American Airlines  (AAL), Doug Parker, came on Mad Money the week before saying that he would have to participate in any price war that was going on in the group.

Suddenly, Southwest at 11 times earnings and American at five times earnings looked very expensive because you know the estimates can't stay this high in a price war.

But today Kelly came out and said he isn't going to add capacity at 8%, he's capping it at 7%. Now, that's not exactly a total rollback. The fact is, though, it does signal there could be a truce budding, and if that is the case, the stocks suddenly look a lot less dangerous because estimate cuts might now be muted or not be happening at all. That means we may have bargains on our hands after all, especially if oil goes lower.

Finally, there's the total matter at hand that we find ourselves facing every single day: the takeover world.

Take Altera  (ALTR).

Three months ago this specialty semiconductor stock sold at 25 times earnings. Frankly, that's quite a steep price, much higher than the average stock but with a growth rate that was lumpy at best with a price war. Actually, an endless price war against Xilinx  (XLNX), a smart competitor. We know that the semiconductor stocks were valued at elevated levels because there had been tons of takeover talk around. If anything, Altera looked like a certain short.

Then Intel (INTC), a very, very good company, paid $54 in cash for the stock -- cash! -- and now you have an incredibly expensive stock selling at 40 times earnings.

But all I can say is "so what?" Altera may not be the S&P price-to-earnings microcosm that the intelligentsia wants all stocks to trade at. It might not make any sense given the competitive threats out there.

Does it really matter, though? You want to argue with the biggest semiconductor company in the world? You want to tell CEO Bryan Krzanich that he's not playing by the rules? That he's overpaying to get out of the plain old PC business.

I think I will just take a pass on that accusation. The answer is, he knows more than I do.

So, there you have it. A series of situations that are cheap or looked expensive and aren't or are going for whatever price the market will bear.

I say that's just how it should be

Is the market therefore overvalued? Let's just say the market is the sum of what people and companies and acquirers and seekers of income and desirers of growth will pay. I would like to think of it as fairly valued, with pockets of undervaluation like Apple, segments that are in flux in their valuation like the airlines, and then sectors that seemed expensive until a giant like Intel makes them cheap!

Editor's Note: This article was originally published at 4:15 p.m. EDT on Real Money on June 1.

At the time of publication, Jim Cramer's charitable trust Action Alerts PLUS held positions in AAPL and WFC.

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