In the past writings below, I referred to the concept of a fair value for stocks. However, I skipped a step. I did not define what I meant by fair value. So here goes…
To start, let us assume that we are not in extraordinary times (link). Assume that we are in normal times, that the economy is fine.
The first concept is the Price/Earnings ratio. It compares a stock’s 12-month trailing earnings over the current price. For example, currently a major U.S. car company’s P/E is 12x and a cell phone equipment company is 18x. The P/E difference is due to the expected future earnings growth of the cell phone company being higher than the car company’s. Therefore, the higher the future prospects for a company, the higher the P/E ratio of its stock.
Next is the PEG ratio. The PEG ratio is the P/E ratio over the expected growth rate in earnings. A company that is 15x earnings which is expected to grow earnings at 15% has a PEG ratio of 1 (This is considered fair value, some would argue for a higher number). Below 1 (or 2), the stock is cheap, above …expensive. Yahoo finance is an excellent webpage to find this out and more on almost all stocks.
Lastly, because earning can be volatile, a leading economist, Robert Shiller developed the Cyclically Adjusted Price Earnings ratio (CAPE10). This ratio is based on average inflation-adjusted earnings from the previous 10 years instead of just the last trailing 12 months. It is believed to be a more accurate measure.
Of course, due to a cornucopia of various factors, the CAPE10 ratio is a poor predictor of short-term movements in stock prices (and there is certainly no shortage of various factors lately). Lazlo Birinyi well documents this (he continues to call for higher prices). However, over the longer term, I believe the inevitable gravity of fair value pulls on prices (link).