though inflation, which raises interest costs, causes a corresponding re-
duction in the real value of corporate debt. In inflationary times the im-
pact of rising prices on fixed corporate liabilities could be substantial.
The bottom line is that some accounting practices understate the
true earnings of firms.
HISTORICAL YARDSTICKS FOR VALUING THE MARKET
Many yardsticks have been used to evaluate whether stock prices are
overvalued or undervalued. Most of these measure the market value of
the shares outstanding relative to economic fundamentals, such as earn-
ings, dividends, or book values, or to some economic aggregate, such as
the gross domestic product (GDP) or total replacement cost of the capi-
tal stock. Stock prices are often said to be “high” if these ratios exceed
their historical average value. Yet one has to be very careful when exer-
cising this judgment. The following are a set of commonly used valua-
tion measures.
Price-Earnings Ratios
The most basic and fundamental yardstick for valuing stocks is the price-
earnings ratio. The price-earnings ratio (or P-E ratio) of a stock is simply
the ratio of its price to its annual earnings. The price-earnings ratio of the
market is the ratio of the aggregate earnings of the market to the aggre-
gate value of the market. The P-E ratio measures how much an investor
is willing to pay for a dollar’s worth of current earnings.
The single most important variable determining the P-E ratio for an
individual stock is the expectation of future earnings growth. If in-
vestors believe future earnings growth is going to be high, they will pay
at a higher P-E ratio than they will pay if they expect earnings to stag-
nate or decline. But earnings growth is not the only factor influencing
the P-E ratio. P-E ratios are also influenced by other factors such as in-
terest rates, risk attitudes of investors, taxes, and liquidity.
The P-E ratio of the entire market, based on the most recent 12
months of reported earnings, is shown in Figure 7-2. It has fluctuated be-
tween a low of 5.31 in 1917 and a high of 46.71 in 2002. Its average his-
torical level is 14.45.
The very high number recorded for 2002 is due to very special cir-
cumstances. It is not the “bubble” in market prices that prevailed at the
end of the last century. Instead, as we will discuss in the next chapter, it is
related to the collapse in reported earnings caused by a few technology
110 PART 2 Valuation, Style Investing, and Global Markets