Here's 2 Quick Ways to Value Equity Markets

The market is overvalued it's going to crash! No, it's undervalued now is the time to buy! There are many ways to value financial markets, however two ratios make it quick and easy to develop a perspective on current market conditions.

1. Shiller PE Ratio
2. Tobin's Q Ratio

The Shiller PE Ratio (P/E 10 Ratio) was developed by well-known economist Robert J. Shiller. This ratio builds off the fundamental concept of the P/E ratio, however it has been manipulated into the P/E 10 Ratio by Robert Shiller, Benjamin Graham and David Dodd. Graham and Dodd believed that fluctuations in the business cycle can create inaccurate P/E ratios, thus they believed in using an average for earnings over 10 years. Robert Shiller adopted this approach and adjusted the earnings for inflation in order to provide a more accurate comparison to historical data.

*I apologize that I couldn't include the graphs in the post, however they are included in an attachment.*

The Shiller P/E ratio isn't a technical indicator and can't tell when a bear or bull market may begin, however when coupled with the Q ratio, these two indicators can help determine whether the markets or under or overvalued.

Tobin's Q Ratio was developed by James Tobin of Yale University; the Q ratio is calculated by dividing the market value of a firm by its total asset value. A Q ratio between 0 and 1 indicates that the stock is undervalued; while a Q ratio greater than one indicates that a firm's stock is more expensive than its replacement cost.

Q Ratio = Price of the Market/Replacement Cost of its Companies

Additionally I used the geometric mean as opposed to the arithmetic mean due to its ability to capture both positive and negative returns over a given period of time. Now in order to understand how the ratio has changed with respect to S&P 500, adjusted for inflation, the following graph is provided.

The Q ratio displays points in time when the market was deemed overvalued, and whenever a new high was reached there was a corresponding drop in market value. Both the Q ratio and Shiller P/E ratio follow each other rather closely, and when used together can provide investors with a perspective of the markets value with an accurate comparison to historical data. A disadvantage of the Q ratio is that the Flow of Funds data used to calculate the ratio is over two months old when the data is released, thus the ratio is more beneficial for developing long-term expectations of the market.

Summary and Conclusions

• When used together the P/E 10 and Q ratio provide a sound perspective on the valuation of the market
• The references below go into greater detail when explaining both ratios and are worth the read
• My purpose was to introduce you, the reader, to concepts you may be unfamiliar with and hopefully motivate you to google around and learn more, thanks for reading!

Note: I am by no intention trying to provide investment advice or trying to state which way the financial markets may be moving. My intent is to simply bring to light concepts that readers may have not heard of and provide a brief education on each topic. Thanks for reading.

References
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