George, the blogger at the Investing Online AI blog, has written a post advocating the use of P/E10 to know when it is dangerous to own stocks. George learned about Valuation-Informed Indexing from a Guest Blog Entry that I wrote at another site and we had a long telephone conversation the other night in which we discussed the wonders of the P/E10 stock valuation metric. His blog entry is titled P/E10 — A Tool for Investing.
Juicy Excerpt: If there were a way to know if the market was overvalued, that would definitely help. We could buy stocks or the index when it was cheap, and sell when it was expensive. This is the notion of value investing, and the strategy that Warren Buffett used to become the wealthiest person in the world.
The best measurement that I have found so far of whether an index is overvalued or undervalued is the P/E10. I read about it over at Passion Saving.com. Most people measure the value of a stock or index by the P/E ratio. This is the price of the stock (or index) divided by the annual earnings. The problem with the P/E ratio is that it fluctuates wildly as earnings change from year to year, or even quarter to quarter.
The P/E10 solves this problem because it averages 10 years of earnings. This makes it smoother and more useful. In fact, it makes it an accurate predictor of future index values. I think the real value to investors is that it tells us whether the market is too high and eventually going to fall.