Why the Stock Market Is NOT Overvalued

If you look at stocks like Shopify (TSX:SHOP)(NYSE:SHOP), you might think the market is overvalued, but it isn’t.

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These days, it’s quite common to hear people say that the stock market is overvalued.

If you exclude the absurdly brief bear market of 2020, then stocks have been rising for more than 11 straight years. The S&P 500‘s average return over the last 10 years is 13.6%–way ahead of the historical average. So it looks like stocks are getting overheated.

It may be that a short-term pullback is in order. But stocks, as a whole, are not overvalued. Yes, prices are rising, but earnings are rising even more. If you think of a stock’s valuation as relative to earnings, then most stocks have been getting cheaper.

The market P/E ratio is coming down

For the better part of a year, the S&P 500 was trading at a historically high 35 P/E ratio. That’s the highest it was since about 2009–right in the middle of the great recession. In that period, stocks were crashing, but a global recession was taking earnings lower. So we had stocks that were trading at extreme multiples after a string of earnings misses.

A 35 P/E ratio is higher than the historical average for the market, which is about 18. At 35, investors have cause for concern.

The thing is, the stock market P/E ratio is actually trending down. According to multpl.com, we’re currently at 29. 2021 has seen a lot of companies recover from the damage they took in 2020, so earnings have been rising even faster than stock prices. If you look at bank stocks, for example, many of them have been growing earnings at 50% year-over-year, or more. Tech, too, is also doing pretty well on earnings.

Tech stocks are no longer as overvalued as they used to be

If you’ve ever wondered why stocks got so expensive, there is just one word that will answer your question:

Tech.

Over the last 10 years, tech stocks like Shopify (TSX:SHOP)(NYSE:SHOP) have gotten very pricey. Prior to this week’s earnings release, SHOP was trading at 44 times sales, 200 times adjusted earnings, and 73 times GAAP earnings. And as Canada’s largest stock by market cap, it has a heavy weighting in the TSX Index. With tech stocks like SHOP getting so big and so expensive, the markets got expensive right along with them.

The thing is, these big tech stocks aren’t as expensive as they used to be. Yes, their stock prices are rising, but their earnings are rising far more. In its most recent quarter, Shopify’s revenue grew 46%. Profit also grew tremendously. Yet the stock only went up about 9%. So, relative to earnings, SHOP got cheaper.

Value has room to run

Another reason to think that stocks aren’t too expensive today is the fact that value stocks are still very cheap.

If you look at value stocks like The Toronto-Dominion Bank (TSX:TD)(NYSE:TD), many of them trade at 10 times earnings and have dividend yields well above 3%. These are not the characteristics of overvaluation. TD Bank has had a 13.5% compound annual growth earnings growth rate over the last five years. For a stock to trade at just 10 times earnings when its growth is that high, suggests that it is undervalued. So while tech stocks may be cooling off, value stocks like TD appear to still have room to run.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Andrew Button owns shares of The Toronto-Dominion Bank. The Motley Fool owns shares of and recommends Shopify. The Motley Fool recommends the following options: long January 2023 $1,140 calls on Shopify and short January 2023 $1,160 calls on Shopify.

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