How do I know if I paid too much?

Posted by admin on February 16, 2010 in Investment Information

Professional investors or bloggers often say or write that the stock market or the real estate market is over-valued or under-valued. What exactly are they basing this analysis on? How do you know if you paid to0 much for stocks or real estate or whether you got a deal?

Share prices are an expectation of future return. If a share price is high, this means the market believes the future is bright. If the share price is low, and sometimes the share price can drop below the value of the assets of the company, the market has low expectations of the future growth of the company.

The typical (although not a perfect) manner of measuring this expectation is the price to earnings ratio (p/e ratio). The p/e ratio is calculated by price per share/annual earnings per share. In plain English, it measure how many years it would take for an investor to get back their money (removing the time value of money). For example, a p/e ratio of 20 means that a $1 invested today would take 20 years to return.

Is there such a thing as an ideal p/e ratio? On an individual basis, an ideal p/e ratio is a relative measure. For example, the p/e ratio for a consumer staple stocks tends to be relatively modest (typically under the mid-teens). A supermarket trading for less than the industry standard may indicate that it is in trouble or has little growth potential left. Conversely, a supermarket trading for well above the industry p/e ratio may be a market darling but will eventually come back down as it reverts to the mean.

The S&P 500, arguably a good sample of how the stock market is doing as a whole, is often a good gauge of whether one may have overpaid for a stock (or an index fund if you are an ETF investor) and whether the market as a whole is too hot, cold or just about right.

The p/e ratio of the S & P 500 is approximately 14 at this point which most experts believe is a reasonable valuation, bearing in mind that perception of risk is subjective. The typical rule is that a p/e ratio of over 20 means the market is over-valued (the p/e ratio of the S & P 500 during the tech boom reached 24 at times) whereas a p/e under 10 may mean there are bargains to be had (the p/e ratio before 1985 was in single digits).

My rule of thumb is that if a stock or an index has a p/e ratio over 16, I tend to shy away from buying (I am not a small-cap investors and, hence, the ceiling of my p/e ratio tolerance is relatively low).

Real estate valuations tend to influenced by more subjective factors. For example, a young couple with kids may pay a premium to live close to their parents. However, stripped of these subjective factors, what is a fair price to pay for real estate?

William Bernstein formula probably pleases no real estate agent. Taking as an assumption that the opportunity costs of investing in real estate would be a 6.7% nominal return on stocks and bonds, Bernstein determined that no homeowner should ever pay more than 15 years worth of fair rental value for any residence. For example, a 3 bedroom house which rents out at $2,000/month should not be purchased for more than $360,000.

To state this another way, Bernstein has placed a p/e ratio of 15 on real estate; in the abstract, a fair valuation if you believe real estate is an investment (which it is not for your principal residence).

The other way of looking at real estate valuations is not if you paid too much but can you afford what you paid for your home? The rule of thumb tends to be never take out a mortgage which is twice your salary. Last time I wrote this rule, there were several comments about how unrealistic this was. Since no one can tell the future, it remains to be seen whether this is an out of date rule or we continue to live well beyond our means as real estate consumers.

2 Comments on How do I know if I paid too much?

By jesse on February 17, 2010 at 1:24 pm

Excellent article. For a detached house, looking at about 180X monthly rent is about right. For a condo or apartment, the ratio should be lower, probably no more than 130X monthly rent, because the price you pay should account for future density increases. For a detached house, future density increases would tend to increase future rents and thus a higher “P/E” ratio.

By admin on February 17, 2010 at 2:14 pm

Jesse- the local variance to keep in mind is inventory. If there are too many condos or houses in the local markets, a purchaser should adjust accordingly.