The P/E is a good starting point for valuation. It can never be considered a pure metric, though, because of changing expectations about interest rates and earnings growth. Nevertheless, there are rules of thumb that can help assess whether the P/E is appropriate or not.
The first is to compare the current P/E with interest rate yields. These provide competing rates of return. The yield on stocks is the inverse of the P/E (E/P). The current 16.8 P/E, for example, represents a yield of 5.96%. This is well above the current yield on the 10-yer note of 4.64%. This implies that stocks are significantly undervalued.
Another rule of thumb is that the P/E should be about 20 less the rate of inflation. At about 2 1/4% or so, the inflation rate implies that the P/E should be about 17.8. By this approach, stocks are also undervalued.
http://www.briefing.com/Investor/Private/OurView/TheBigPicture.htm
The first is to compare the current P/E with interest rate yields. These provide competing rates of return. The yield on stocks is the inverse of the P/E (E/P). The current 16.8 P/E, for example, represents a yield of 5.96%. This is well above the current yield on the 10-yer note of 4.64%. This implies that stocks are significantly undervalued.
Another rule of thumb is that the P/E should be about 20 less the rate of inflation. At about 2 1/4% or so, the inflation rate implies that the P/E should be about 17.8. By this approach, stocks are also undervalued.
http://www.briefing.com/Investor/Private/OurView/TheBigPicture.htm
