One of the basic questions that is brought up time and again is: Is the stock market overvalued or undervalued? Investors are chronically asking this question and the debate between the two factions is what creates a market. Those who think their stocks have had their run will sell and those that think that those stocks can continue to run will buy and where the two meet is the price of the stock. The question for you is which side of that trade do you come down on?
I wish there was an easy answer here, but there is no easy answer. I don't subscribe to any one view of it. Efficient market theorists insist that the price of a stock is always justified because that is what the market values it at. Well.... that's nice, but kind of useless. Then, to quote Cheech Marin's character at the end of From Dusk Till Dawn, "One place's just as good as another". Put in terms of market history, buying Microstrategy (MSTR) at $3,000 a share in March of 2000 made just as much sense as buying Ford (F) at $1 in late 2008.
Dismissing this idea for a moment, how then should stocks, or the stock market at large, be valued? One idea for the overall market is by relative valuation. This is the previously mentioned earnings yield (1/PE * 100%) and compare it to long term bonds. If the earnings yield is at 5% and the 10-year Treasury Note is at 3.5%, stocks seem cheap. If the earnings yield is at 4% and the 10-year Treasury Note is at 7%, stocks are horrifically overvalued. There are some problems with this method in that it is possible that the "E", or earnings, in the PE ratio may be temporarily distorted. Also, interest rates can change in a hurry. It is not uncommon for long term rates to move 100 basis points in a six week period.
If you have taken a microeconomics class that has discussed financial markets at all, or any finance class, you have heard of the Dividend Discount Model. There are two problems with this as well. One is that many companies do not pay dividends, or do not pay particularly large dividends as a matter of policy. As a result, these companies get the shaft in this method of valuation. Also, you have to make the leap of faith that some given level of dividend growth will be sustainable. Just because a company has grown dividends at 8% each year for the past ten years does not mean that they will continue to do so. Case in point: the financials during the 2007-2008 period. If you valued those companies with the assumption that their current dividends were a good proxy of their dividends over the next five years, you would get hosed. Purely conceptually, however, this is probably the best method. It's just that it is difficult to apply to a large number of stocks.
There is the fundamental problem of what measure of earnings to use for the PE measures. Do you use what nearly all financial websites show with the past year's earnings? What if the past year is distorted by asset divestitures or large one time write-offs of intangible assets? Perhaps you can use the analyst forecasts for the earnings over the next year. However, are the analysts even close? Historically, they've proven that they don't really know what they're doing, but that might not be fair. Forecasting is not a whole lot better now than it was 25 years ago. For the overall market, Yale economics professor Robert Shiller has proposed using a ten-year trailing average of earnings to smooth out the wild swings to the upside and downside and establish a better sense of what "base" earnings are. However, this measure fell short during the 1990s as earnings accelerated at rapid rates and did not return to earth in any sustainable way. By the 10-year average, stocks were heavily overvalued as early as 1996, but have not returned to those levels except for a brief spell in early 2009 that was quickly reversed.
Then of course, there is the issue with PEs of what is a level that indicates a good buy. This is entirely reliant on the growth rate of the company. Apple (AAPL) at a PE of 30 was a better buy than Bank of America (BAC) with a PE of 12 in 2007 because its future earnings were poised to grow much faster. In fact, in this case Bank of America (BAC) saw its earnings disappear and turn into ginormous (that's a technical term) losses. That being said, a high PE (provided that there are no special factors) will necessarily mean that you are more vulnerable to price declines should market expectations prove incorrect. This was the case in a big way during the 2000 Tech Bubble crash.
There are a series of different measures outside of dividends and earnings that each have their own problems. Price to sales ignores the fact that a company can have rapidly increasing sales, but collapsing profit margins. Price to cash flow is a nice measure, but if a company has put off needed capital outlays, this can be distorted too. Price to book value varies heavily by industry as financials have much lower price to book ratios than others. It goes on and on.
In any case, I think this provides more questions than answers, but at least the questions are there if you have not thought of them before.