Are Stocks Overvalued?

by Richard W. Kopcke
September/October 1997

By most standards, the price of equities in the United States has risen remarkably rapidly during the last 15 years. Since 1994 alone, the Standard & Poor's index of 500 stock prices has doubled. Although the rapid growth of corporations' profits has propelled the price of their stock, shareholders also are willing to pay a greater price per dollar of their companies' profits, and the valuation of corporations' earnings is now nearly as high as it has been since World War II. For the moment, the value of equity may rest on the growth of earnings, but in the longer run the price of stocks depends on the return that corporations earn on their investments, the growth of their opportunities for making new investments without sacrificing their return, and the return that shareholders require of their stocks.

This article compares the recent price of stocks to traditional standards for valuing equities, finding not only that prices are high by almost all measures but also that the appreciation of equity has been exceptionally dependable. The author uses a simple model to compare the recent data for returns and growth with the value of equity, concluding that companies' recent performance does not support fully the current price of stocks. Although the current values of corporations' assets and earnings in financial markets exceed those that prevailed in the 1970s, the rate of return earned by corporations is only three-quarters as great as it was in the 1970s. The author concludes that a lower shareholders' discount rate, perhaps fostered by the consistently high growth of profits during much of the 1990s, could explain the prevailing value of equities.

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