Stock valuations for the year ending 2006

We often hear things in the stock market like (P/E) ratio. So what does this indication really mean. In general this means using measurements to determine if stocks are valued higher or lower that the historical mean.

The year of 2006 is almost coming to an end and the DOW is at historical high at 12,000 level
The price to earnings (P/E) ratio has outpaced the rise in the S&P 500 index during the past two years. In the third quarter of 2004, the S&P 500 P/E ratio was 20.3, in the third quarter of 2005 it was 18.4, and the just completed third quarter of 2006 has a P/E ratio of 17.5. If you look at operating earnings the numbers are even better, with a current operating P/E ratio of 16.0.

Therefore the decline in the P/E ratio is a bullish factor. As long as this type of earnings growth continues to outpace the market, the rally will continue. Athough the current P/E ratios are slightly above historical averages, but nevertheless represent very good value given current economic conditions.

A standard starting point used in the market for valuation is to compare the P/E ratio based on expected future year earnings to the yield on the 10-year Treasury bond. On this basis alone, stocks could be considered significantly undervalued. The P/E ratio for the next twelve months based on just 5% growth in operating earnings is 15.3. That is equivalent to a 6.6% earnings yield (this is earnings divided by price). That compares extremely favorably to a current 4.7% yield on the U.S. Treasury 10-year bond. By this measurement stocks could be currently undervalued by over 40%.
So the overall market is fairly bullish, and as long as inflation is kept in check that the market could continue to rally . Of course there are always the unknown factors, including world events such as terrorist and oil factor which can always change things quickly. But for now, these factors are aligned in a bullish way.