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Sunday, May 30, 2010

Does the market deserve to be this over-sold? Value analysis might surprise you

Stocks just finished May with a fairly awful performance. As I looked through some of the data generated by my Alert HQ process I saw some of the indicators had actually gotten worse than during the period around March 2009 and others were getting close.

I had to ask myself the question that is the title of this post: Does the market deserve to be this over-sold?

Stocks can continue in an over-sold state until fear dissipates, values become compelling and buyers are motivated to return to the market. Are we at that point yet?

Fear is difficult to quantify but we can put a number on value. Common measures of value are Price-Earnings ratios (PE) and Enterprise Value-to-EBITDA ratios. EBITDA is earnings before interest expenses, taxes, depreciation and amortization. Many investors prefer to look at the EV-to-EBITDA ratio because it avoids some of the games that can be played when calculating the earnings component that goes into the PE ratio.

PE Ratio analysis --

The following table shows a breakdown of stocks into categories based on PE. Typically PE less than 16 implies that a stock is still a reasonable value, 16 to 30 means the stock may be getting a bit pricey but almost all growth stocks are in this range so it is not necessarily a bad thing. PE greater than 30 is definitely getting away from value.

Description Count % of total
No PE available or PE less than 0 (ie: not profitable) 1841 34%
PEs less than or equal to 16 1711 31%
PEs between 16 and 30 1065 20%
PEs greater than 30 822 15%
Count of all stocks 5439 100%

As this table shows, roughly one third of stocks are not profitable at all, roughly have of all stocks are reasonably priced and only 15% of stocks are over-priced. Indeed, almost one third of stocks are in the sweet spot where PE is less than 16.

PE analysis does not suggest to me that stocks are over-valued and deserve to fall further. There are always tons of companies that are unprofitable, even during the best of times. Most stocks seem to be fairly valued or are even somewhat cheap

EV-to-EBITDA analysis --

This next table takes the same approach as above while looking at the EV-to-EBITDA ratio.

Description Count % of total
No EV-to-EBITDA value available or EV-to-EBITDA ratio less than or equal to 0 (ie: not profitable) 2090 38%
EV-to-EBITDA ratio less than or equal to 6 718 13%
EV-to-EBITDA ratio between 6 and 12 1591 29%
EV-to-EBITDA ratio greater than 12 1042 19%
Count of all stocks 5439 100%

The results here are very similar to our PE analysis. Roughly a third of stocks are apparently unprofitable. Nearly half of all stocks are good values or decent values. Less than 20% are pricey.

Conclusion --

The market certainly does not appear to be over-valued here. Based on the analysis laid out above, it is hard to see why stocks should fall any further.

On the other hand, there is still fear of Europe, fear of financial reform, fear the job market is not improving fast enough, fear of Obama, fear of inflation, fear of deflation, etc. In other words, the usual litany of issues that the bears so delight in describing over and over.

There is always worry about the future. What's so different about this list of worries? Not all that much. Eventually, the fundamentals will win out and value will be recognized. It shouldn't be long now.

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