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Comment by christophilus | Hacker News Reader

You can estimate the earnings yield you get on a business based on its price. So, if you have a lemonade stand that earns $100 per year, and you buy it for $100, that’s a great price. You’ll make your money back in a year. After that it’s profit, baby! If you pay $100000, it’ll take 1000 years to earn back your original investment in nominal terms. But it still might be an OK investment, if you are very certain that you can double earnings every year for long enough.

That’s basically how you evaluate what to pay for a company. When you buy stocks, you buy fractional ownership in a company.

Edit: many think the market is overvalued, because it’s currently at historically high price relative to the estimated earnings potential. This, while risk of insolvency for many companies is much higher.

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>historically high price relative to the estimated earnings potential

It's high compared to expected earnings over the next year. Which is to be expected, because the ratio of expected lifetime earnings over expected 12 month earnings is also at a high, owing to a pandemic significantly impairing earnings for a year or so but not forever. Looking at 12 month numbers is usually fine as a proxy, but terrible now.

There's even a historical graph of this, called the Shiller P/E Ratio: https://www.multpl.com/shiller-pe

We are still at the highest point ever except for the dotcom bubble and black tuesday of 1929 (and directly before the recent crash, although not by much).

So to answer the parent, pick a ratio somewhere below that. Price has been the main thing moving upward disproportionately for the past decade, now earnings will take a dive.

The Shiller Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years and the recent earnings weren't really affected by the virus yet and thus the current 10 years of earnings happen to align with the longest period without a recession in US history so it's no surprise that metric is high. The current P/E ratio is 20.53 [0] and there have been many periods in which it has been higher.

[0]: https://www.multpl.com/s-p-500-pe-ratio

We still require a 25% drop in P/E to bring us back to the historical mean. There are reasonable arguments as to why we may never mean revert, why this time is different (possibly permanently low interest rates, stocks as a leading indicator of future inflation due to Fed printing inflating asset prices , etc). But as a rule, I like to bet on mean reversion, not against it.

High Shiller P/E doesn't necessarily mean stocks are overpriced. Intrinsic value is based on future cash flows, what happened 10 years ago may or may not be relevant to future cash flows.

My point was - people say stocks are overpriced, presumably vs their intrinsic DCF valuation. Why do people conclude that without making a valuation?

What makes you think that they aren’t?

That I have asked this a bunch of times - "What would be an appropriate price and how did you come up with that number?" - and never got a reply.

Historical rate of return on stocks is about 7%. So in theory, a stock trading at a price to earnings ratio of 14 or less is good value, whereas a stock trading at 15 times earnings is not so much.

However, other factors could play a part, as certain industries are favoured over others, risk, projecting earnings growth, etc.

As such, you can make the argument that stocks are overvalued because they're trading at all time or near all time highs in terms of price to earnings ratios and other metrics. And especially so now given that projected future earnings will have dropped considerably while stock valuations have not.

> Historical rate of return on stocks is about 7%. So in theory, a stock trading at a price to earnings ratio of 14 or less is good value

Why? I'm not saying it's incorrect but I've never seen such an approach to valuation.

For 7% a P/E of 14.285714285 or less would be good to be very precise.

> And especially so now given that projected future earnings will have dropped considerably while stock valuations have not.

Really that depends on your time horizon. The Fed has signaled that it is willing to act aggressively to boost AD, so that seems to me to be a signal that projected future earnings will not be that low.

If many restaurants, event spaces, etc. fail then it’s possible many people will have to liquidate their savings. This sell pressure would push down prices and likely cascade. The market thus far has been protected by stimulus funds, generous ui benefits, etc. Could that slack be taken up? Sure but it seems unlikely, especially with a second wave of shutdowns. Trying to predict the bottom or top is a fool’s errand. I’m also not sure how ETF/Index funds dispose of assets when they’re sold. They may be a dam holding back a flood.

The answer is they don't know how to value cashflows or businesses, they just buy brand names they like.

There's a good interview with Michael Mauboussin[0] in which he mentions the power of regression to the mean and base rates. He gets those ideas from Daniel Khanmen, I think. Anyway, an appropriate price is impossible to predict ahead of time, but using reversion to the mean as your guide, you see that we're pretty overvalued right now.

We're above the mean earnings ratios, FCF yields, etc, while at the same time knowing that we're almost certainly in the first leg of a major recession, and a period unprecedented economic uncertainty.

I think the bear case is much stronger than the bull case right now.

[0] https://www.youtube.com/watch?v=X5xoKZBcS4Y

>Why do people conclude that without making a valuation?

Most retail investors are not making any valuations whatsoever. The investment criteria is "this company's future is bright/bad", even though price is the most important factor. Then, recent momentum makes you look good...for now.

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