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Pat Dorsey, CFA, is Director of Equity Research at Morningstar, Inc. He played an integral part in the development of the Morningstar Rating for stocks, as well as Morningstar’s economic moat ratings. Dorsey is also the author of three excellent books;The Five Rules for Successful Stock Investing:, and The Little Book That Builds Wealth.Heholds a master’s degree in political science from Northwestern University and a bachelor’s degree in government from Wesleyan University.

Morningstar’s Pat Dorsey outlines the major competitive advantages that give superior companies the power to stay on top.

Highschool is an important part of preparing for the real world, but they don’t teach you everything you need to know about finance before you leave highschool. There are important things that everybody should understand before taking charge of there own economic destiny. Here are the five most important things to understand.

1. Compound Interest

Compound interest means that interest earned begins earning interest itself. What this means is that each year that you have money invested in something which earns compound interest, you will be earning more money than the last. As an example, say you have an account that earns ten percent compound interest. If you invest 1,000 dollars, then next year you will have 1,100 dollars. The year after than you might think that you would have 1,200 dollars. But with compound interest, the interest itself earns you more interest. This means that on the second year you would have 1,210 dollars. By the tenth year you would have 2,594 dollars. Compare this to the 2,000 you would have if it had been standard interest. After decades the difference becomes much more noticeable, with three decades earning you a total of more than seventeen thousand dollars, versus the four thousand you would have on standard interest. Investing in compound interest and avoiding paying compound interest is therefore extremely important in the long term.

2. Inflation

Every year, money is worth less than it was the previous year. This is because the government prints more money every year, which makes the dollar buy less. For this reason, it is important to invest money in things that increase their value at at least the same speed of inflation.

3. Risk

It is important to realize that while there is in fact risk in everything, the level of risk can be drastically different. When looking at investments, it is just as important to look at the risks involved as the rewards. If, for example, there is a 90 percent chance that something will earn you a thousand dollars and a ten percent chance that it will lose you nine thousand dollars, than ultimately if you choose to invest in these types of situations you will find that over time you are not gaining or losing any money.

4. Sunk Cost

A sunk cost is a value of money which has been spent on something and can no longer be recovered. The amount of money that you have already spent on a car or the amount of years that you have already worked at a job are good examples of a sunk cost. People often make the mistake of sticking with a decision because they have spent so much time on it, but if is a losing game the situation should be changed as soon as possible no matter how much time was spent doing things a different way in the past.

5. Leverage

It is important to understand what is happening when you take out a loan. By paying the interest you are spending much more than if you bought it up front.

Louise Baker ranks online degrees for Zen College Life. She most recently wrote about the best colleges online.

I update market valuations on a monthly basis. The point of this article is to measure the stock market based on six different metrics. This article does not look at the macro picture and try to predict where the economy is headed. It only uses these six metrics which have been very good past indicators of whether the market is fairly valued.

I collaborate with my colleague Doug Short for some of the data in the article. Doug is an expert on market valuations, and I encourage readers to visit his site dshort.com

As always, I must mention that just because the market is over or undervalued does not mean that future returns will be high or low. From the mid to late 1990s the market was extremely overvalued and equities kept increasing year after year. However, as I note at the end of the article I expect low returns over the next ten years based on current valuations.

To see my previous market valuation article from last month click here..

Below are six different market valuation metrics as of September 1st, 2010:

The current P/E TTM is 15.8 , which is lower than the TTM P/E of 18.2 from last month.

Click to View

This data comes from my colleague Doug Short of dshort.com.

Based on this data the market is fairly valued. However I do not think this is a fair way of valuing the market when considering the significant decrease in earnings over the past year. To get an accurate picture of whether the market is fair valued based on P/E ratio it is more accurate to take several years of earnings.

Numbers from Previous Market lows:

Mar 2009 110.37

Mar 2003 27.92

Oct 1990 14.21

Nov 1987 14.45

Aug 1982 7.97

Oct 1974 7.68

Oct 1966 13.96

Oct 1957 12.67

Jun 1949 5.82

Apr 1942 7.69

Mar 1938 10.63

Feb 1933 14.92

July 1932 10.16

Aug 1921 14.02

Dec 1917 5.31

Oct 1914 14.27

Nov 1907 9.35

Nov 1903 11.67

Historic data courtesy of [www.multpl.com]

Current P/E 10 Year Average 19.84

The current ten year P/E is 19.84 ; this is lower than the PE of 20.05 from the previous month. This number is based on Robert Shiller’s data evaluating the average inflation-adjusted earnings from the previous 10 years. Based on my colleague, Rob Bennett’s market return calculator, the returns of the market should be as follows:

My colleague Doug Short thinks this numbers are a bit inaccurate, because the number I used as it does not include the past several months of earnings, nor revisions. Doug calculates P/E 10 at 20.00.

Click to View

Mean: 16.37

Median: 15.76

Min: 4.78 (Dec 1920)

Max: 44.20 (Dec 1999)

Numbers from Previous Market lows:

Mar 2009 13.32

Mar 2003 21.32

Oct 1990 14.82

Nov1987 13.59

Aug 1982 6.64

Oct 1974 8.29

Oct 1966 18.83

Oct 1957 14.15

June 1949 9.07

April 1942 8.54

Mar 1938 12.38

Feb 1933 7.83

July 1932 5.84

Aug 1921 5.16

Dec 1917 6.41

Oct 1914 10.61

Nov 1907 10.59

Nov 1903 16.04

Data and chart courtesy of [www.multpl.com]

This is moderately over valued from the average P/E as shown above.

Current P/BV 2.09

This is a very rough estimate, it is nearly impossible to get an exact number for P/B on a specific date to my knowledge.

The current P/BV is 2.07; this is below P/B of 2.09 I measured in my previous article.

The average Price over book value of the S&P over the past 30 years has been 2.41. This indicates the market is undervalued. Book value is considered a better measure of valuation than earnings by many investors including legendary investor Martin Whitman. He states that book value is harder to fudge than earnings. In addition book value is less affected by economic cycles than one year earnings are. P/BV therefore provides a longer term accurate picture of a company’s value, than a TTM P/E.

Current Dividend Yield 2.04

The current dividend yield of the S&P is 2.04. This number is higher than the 1.99 yield from last month.

It is hard to determine on this basis whether the market is overpriced. The dividend yield for stocks was much higher in the begging of this century than the later half. The dividend yield on the S&P fell below the yield on Ten-Year treasuries for the first time in 1958. Many analysts at the time argued that the market was overpriced and the dividend yield should be higher than bond yields to compensate for stock market risk. For the next 50 years the dividend yield remained below the treasury yield and the market rallied significantly. In addition the dividend yield has been below 3% since the early 1990s. While I personally favor individual stocks with high dividend yields, I must admit that the current tax code makes it far favorable for companies to retain earnings than to pay out dividends. Finally, as I noted above the current economic environment has zero percent interest rates and low bond yields. During periods where yields are low it is logical for income oriented investors hungry for yield to be bid up the market, and dividend yields to decrease. I think it is hard to claim the market is overbought based on the low dividend yield.

Mean: 4.36%

Median: 4.29%

Min: 1.11% (Aug 2000)

Max: 13.84% (Jun 1932)

Numbers from Previous Market lows:

Mar 2009 3.60

Mar 2003 1.92

Oct 1990 3.88

Nov1987 3.58

Aug 1982 6.24

Oct 1974 5.17

Oct 1966 3.73

Oct 1957 4.29

Jun 1949 7.30

Apr 1942 8.67

Mar 1938 7.57

Feb 1933 7.84

July 1932 12.57

Aug 1921 7.44

Dec 1917 10.15

Oct 1914 5.60

Nov 1907 7.04

Nov 1903 5.57

Data and chart courtesy of [www.multpl.com]

The current level of is 74.9%, is higher than the 73.4% number from last month.

Stock Market Capitalization as a percentage of GDP is another metric albeit less commonly used than other metrics, to value the market. Between 50-74.9% market capitalization as percentage of GDP is considered Modestly Undervalued. However the metric is only a drop away from being in the 75-90% range which is considered fairly valued. Based on Guru Focus data the market should return about 7.2% per year based on the current value.

Warren Buffett has stated that market capitalization as a percentage of GNP is “probably the best single measure of where valuations stand at any given moment.”

According to Barron’s the ratio got as low as 40% in the late 1940s, when investors feared another depression, and in the inflationary 1970s.

Historic Data:

Min 35% in 1982

Max 148% in 2000.

Data and charts courtesy of Gurufocus.com

Current Tobin’s Q 0.94

Click to View

Tobins Q is 0.94 compared to 0.98 from last month.

The data comes from Doug Short. This is the most accurate data that is available. It is impossible for the data to be 100% precise because the Federal Reserve releases data related to Tobin’s Q on a quarterly basis. The best that can be done is to extrapolate the data and try to provide the most accurate data possible based on the change in the Willshire 5000. This is what Doug did to get the current number. This method has proven extremely accurate for calculating Tobins Q on any given day.

The current level of 0.94 compares with the Tobins Q’s average over several decades of data of approximately .72. This would show that the market is overvalued.

According to Doug’s estimates the market is over-valued by 33% based on Q’s arithmetic mean.

Click to View

In the past Tobin’s Q has been a good indicator of future market movements. In 1920 the number was at a low of .30, the next nine years included phenomenal gains for the market. In 2000 Tobin’s Q almost reached a record high of nearly 2, and the market declined subsequently about 50% by 2003.

Historic Tobins Q:

Market Low 1932 0.30

Market High 1929 1.06(this is not the highest number ever reached, just the number reached before the 1929 crash).

Average historic Tobins Q .72 (source: Stocks for the Long Run by Jeremy Siegel)

In my next monthly article I will have more Tobin’s Q historical data.

To Recap

1. P/E(TTM)- Fairly Valued

2. P/E(10 year average)- Overvalued

3. P/BV- Undervalued

4. Divdend Yield- Indeterminate/ overvalued

5. Market value relative to GDP- Slightly (slightly undervalued)

6. Tobins Q- Overvalued

In conclusion the market is definitely not extremely over valued based on the above data. However, one can make the argument that the market is moderately overvalued. With the exception of P/BV, and market cap to GDP all the indicators point to at least a slightly overvalued market.

However the historical data fails to take into account current record low interest rates. I know not many investors take issue with my inclusion of interest rates in the equation. However, I think that most investors look at the stock/bond alternative. Right now you can get some blue chip stocks with dividend yields close to the Ten year treasury yield. I think with taking into account interest rates the market is fairly valued.

However, eventually the market will likely returns to normal valuation ratios as interest rates reach more normal levels. I believe returns over the next 10 years will be sub-par (below the 9.5% average market return). I think we will likely see returns of around that equal inflation over the coming decade.

You can read more about my predictions in the following two articles:

What Will The S&P 500 Return Over The Next 10 Years Part I

What Will The S&P 500 Return Over The Next 10 Years Part II

Disclosure: none

Note: I have received numerous suggestions on how to improve my monthly series. I tried to incorporate these ideas in my current article. Please email me or leave a comment if you would like to provide further suggestions.

Best Books on Market Valuations:

Valuing Wall Street : Protecting Wealth in Turbulent Markets by Andrew Smithers. The book explains in detail how tobin’s Q is calculated.

Wall Street Revalued: Imperfect Markets and Inept Central Bankers. A more recent book by Andrew Smithers.

Irrational Exuberance By Robert Shiller. Great book by the man who calculates the P/E 10 ratio himself, Robert Shiller. The book is written in 2000, right before the tech bubble crash. Shiller correctly predicts the crash.

Disclosure: None

Whitney Tilson

Whitney Tilson the famed value investor, and author of Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger , More Mortgage Meltdown: 6 Ways to Profit in These Bad Times and Value Investing Course: Essential Strategies for Market-beating Returns was recently interviewed on CNBC.

Tilson thinks the penduleum might be swinging in favor of stocks over bonds. Tilson described the current situation as “crazy” in which investors are chasing minuscule yields on long term treasury bonds. I have noted this similar point in previous articles

Tilson commented in a recent email:

s investors fixate on the global forces whipsawing the markets, one fundamental measure of stock-market value, the price/earnings ratio, is shrinking in size and importance.

And the diminution might not stop for a while.

The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company’s earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don’t.

But while U.S. companies announced record profits during the second quarter, and beat forecasts by a comfortable 10% margin, on average, the stock market has dropped 5% this month.

The stock market’s average price/earnings ratio, meanwhile, is in free fall, having plunged about 36% during the past year, the largest 12-month decline since 2003. It now stands at about 14.9, compared with 23.1 last September, based on trailing 12-month earnings results. Based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May.

Needless to say this is good news for equity investors, and bad news for bond investors.

Tilson is bullish on JNJ which has a strong balance sheet, moat, and recently issued debt for a lower price than the stock’s dividend yield.

Tilson is also bullish on Dell and Berkshire Hathaway. Dell is trading at a 9.3 P/E when cash is subtracted from the market capitalization. Tilson believes that Berkshire Hathaway is at least 20% undervalued even on a conservative basis.

Benjamin Graham

by Larry Harmych of http://intelligentinvestors.org/

Preface:

Benjamin Graham’s intellectual paradigm has influenced many successful investors.  These investors, each coming from a town called Graham-and-Doddsville (coined by Warren Buffett), did not all use Benjamin Graham’s investment philosophy in the same way.    Though nuanced as these philosophies were they were still basically the same: buying a dollar for less than a dollar with risk decreasing each cent less.

However, in reading Buffett’s famous article from which the town’s name came a lot was left to be desired.  This is classic Buffett style, saying enough to hook you and then hanging you out to dry.  I believe his reasoning on this to be simple: Buffett wants you to do all the heavy lifting yourself.  Giving away investment secrets would be the intellectual equivalent of that of trust fund babies inheriting money they did not earn (note: Buffett is not fond of trust fund babies).

“Science and philosophy do not progress by regarding their past investments as ends in themselves; the object is always to preserve that which is valuable in the old methods while adjoining new methods that refine their meaning and extend their horizons.” –Christopher M. Langan

The Art of Practical Investment Decision Making, by Larry Harmych

Just as legendary investor Warren Buffett sat under the tree planted by Benjamin Graham, Buffett, too, has planted a tree worthy of men sitting under.  Whereas Benjamin Graham emphasized the quantitative (buying a dollar for fifty cents), Warren Buffett emphasizes the qualitative.  These qualitative factors relate not only to the company one wishes to purchase but also to the one making the purchase.  Though Buffett credits Munger with this modified investment style (an amalgamation of Graham’s style and qualitative factors), Munger gives the credit right back insisting that Warren had been doing this all along.  In fact, much of this style has been drawn from Phillip Fisher and then perfected by Buffett, who early on in his career even characterized his investment style as fifteen percent Fisher.

The most important qualitative factor Buffett emphasizes is staying within one’s own circle of competence.  If you are a petroleum engineer should you be looking for investments in financials?  Surely not.  Look first in your area of expertise.  Buffett and Munger have largely avoided technology stocks altogether.  Peter Lynch, a Buffett devotee, discusses the mistake he made in his book One Up On Wall Street by not staying within his circle of competence, namely Dreyfus and Franklin, missing a potential 100 and 138-bagger:

“I’d been coming to work here for nearly two decades.  I know half the officers in the major financial-service companies, I follow the daily ups and downs, and I could notice important trends months before anyone on Wall Street.  You couldn’t be more strategically placed to cash in on the bonanza of the early 1980s.”

“I was right on top of all of them.  I knew the Dreyfus story, the Franklin story, and the Federated story from beginning to end.  Everything was right, earnings were up, the momentum was obvious.  How much did I make from all this? Zippo.”

It would not be wise to ask your mechanic to do your taxes or your accountant to do your car maintenance; likewise, don’t pretend you’ll be better at investing in oil companies than banks if your work is heavily related to banking.  Do not pretend to know more than you do, expand your circle of competence whenever possible, and know the boundaries of your circle well to avoid potential investing pitfalls.

Another important factor Buffett emphasizes is the quality of a company’s management.  This factor is of paramount importance.  Management’s energy is much like the sun’s in that it is powerful and permeates an organization.  Management should stick to an overarching philosophy and business model that generates trust, promotes quality, and empowers employees.  Buffett exemplifies this himself with his own managerial strategy.  He has complete faith in his management and is completely hands-off when it comes to running his subsidiaries.  How could he be more competent than a management in place that has already proven to grow a successful business that interested him in the first place due to its quality?  Buffett’s latest stock purchase of Fiserv, Inc. has as much to do with quantitative factors as it does to do with qualitative factors, and often times these two go hand-in-hand.  Fiserv’s management is top-notch and Fiserv itself is ranked as #1 in several of the industries it serves.   Quality management will tell you the way it is not the way you want it to be.  Take Lonnie Stout, CEO of J. Alexander’s, as an example, in the company’s latest annual report he says, “I will share with you what I think we did well during this two-year downturn. I will also share with you some things I think in retrospect we should not have done.”  He also called the latest business results “troubling.”  Throughout his letter to shareholders there is a peppering of emphasis on responsibility both fiscally and managerially.  He does not shy away from the truth.  While there are many more factors to management quality, these examples should help to point investors in the direction they should be facing.

Another important qualitative factor is quality of thought.  Although Buffet has always been a better-than-average thinker, it was not until the addition of Munger that Buffett’s thinking power was raised exponentially.  Munger is the human equivalent of a supercomputer and routinely lectures about the importance of mental models.  Since the investor is essentially involved in a game where minds come together to trade perceived value, which is but a subset of a worldwide network of perceptions that makes up the totality of what constitutes reality, it is important to know what drives the mind.  Munger’s essential belief is that the mind is largely driven by psychological factors that were created to automate thinking.  While automated thinking once had biological advantages, it is primitive in its origins and it is not advantageous when deployed by an investor.  The investor’s ultimate goal then is the shape his thinking so that he remains as objective and calculating as ever.  By learning several mental models investors can avoid the psychological traps that most investors fall prey to.  Such models include the concepts of: compound interest, permutations and combinatorics, probability, breakpoint (from engineering), critical mass, cost-benefit analysis, and economics of scale, just to name a few.  Aside from the simple reason that they enjoy it this is why Buffett and Munger are such avid readers—to be more knowledgeable, gain insight, and thus be more objective.  The wise investor does not ignore this crucial qualitative factor, for how can you know the value of anything in the market if you don’t know what constitutes society’s value perceptions?

There are many qualitative factors from which Buffet and Munger gain insight.  None of these should be discounted.  However, more important than spelling them out is understanding why and how they are arrived at.  If an investor understands this then he might just do some thinking on his own and perhaps that is the most important qualitative factor of them all.

Buffet’s tree is not the only tree worthy of sitting under.  A book can be bought online for pennies nowadays or borrowed from a local library for free, yet may contain inside it limitless value.  Study the history of companies, business valuation, accounting, economics, psychology, world history, etc.  Do not read solely from investing books in hopes to find some secret strategy or investing shortcut.  Assemble a mass of knowledge and create a network of mental models.  If all this studying amounts to zero investment gain, look on the bright side, at least you’ll have a vast wealth of knowledge from which you can always draw in making any decision in life.  And maybe one day you too will plant a tree under which other men shall sit.