There is an enormous amount of discussion and even controversy regarding various opinions as to whether the stock market is currently undervalued or overvalued. Some pundits, such as Prof. Schiller, use a statistical analysis that argues for overvaluation based on an alleged reversion to the mean. Currently, Prof. Schiller calculates the Schiller PE on the S&P 500 at 22.4 versus the historical norm of 16. In contrast, the actual PE ratio of the S&P 500 based on current and near earnings estimates is 13.6, which is below the historical norm of 15 to 16, thereby indicating that the market is moderately undervalued.

Regardless as to which side of that argument turns out to be correct, we have long argued that focusing on market valuations is not nearly as important as focusing on individual stock valuations. Is has been our experience spanning over four decades, that regardless of whether we’re in a bear or a bull market, there always exists fairly valued, undervalued and overvalued stocks. Obviously, you’d expect to find more bargains in a bear market and less in a bull market. Nevertheless, there will always be some of both, and there’ll always be some that are fairly valued.

When currently reviewing dividend growth stocks, we are finding many more bargains than we are examples of overvalued companies. However, it’s also important to recognize that even the best-of-breed companies can become overvalued. When this occurs, the levelheaded investor, including the long-term investor, should be willing to acknowledge and recognize overvaluation when it does exist. When emotions are taken out of the equation, valuation comes down to a simple game of numbers. In order to determine whether common stock is overvalued or not, all one has to do is run the numbers and the answer will become clear and evident.

**A History of Nike’s Valuation**

One of our favorite dividend growth stocks is Nike Corp. (NKE), which we first wrote about on October 20, 2009 found here, when we believed it was undervalued. At the time of this initial writing, Nike’s (NKE) stock price was just over $66 a share and its PE ratio was 17.5. We also provided our thesis for growth at the time, and since we believe that nothing material has really changed regarding Nike’s long-term prospects since then, we’ll refer to that article as a reference to our belief in the company’s long-term growth potential.

In a follow-up article we published on April 8, 2010 found here, we indicated that Nike (NKE) had become fully valued, although not overvalued, at a price of approximately $74 and a PE ratio just over 19. In this follow-up article we rated the company a long-term hold, although we indicated that we would not be buyers at that level of valuation, we were also not sellers.

The following series of earnings and price correlated historical F.A.S.T. Graphs™ look at Nike (NKE) with a focus on valuation and operating performance. Our first graph plots Nike’s historical earnings and dividend record since calendar year 1993. Here we clearly see a company with an excellent and very consistent record of above-average earnings growth of 11.1% per annum, and a consistently rising dividend (the blue shaded area).

With our second graph we introduce monthly closing stock prices (black line), and calculate a normal PE ratio (the dark blue line). Here we see that the long-term movement of stock price clearly tracks earnings (the orange line). We also learn that the market has typically priced Nike at a premium to its intrinsic value by applying a blended average normal PE ratio of 18 versus a fair value PE ratio of 15. However, we also discover that every time the price rose above either the blue or the orange line it inevitably returned.

Consequently, we can factually discern that the best time to invest in Nike is when its price is at or below the orange line. We can also clearly see that anytime the price is above the blue line that an investment in Nike is less than optimal at those points. On the other hand, with the exceptions of 1997 and the spring of 1999, the long-term investor in Nike would have made money whether they overpaid for the stock or not. This illustrates the power of consistent and strong earnings growth. On the other hand, had the long-term investor been willing to be patient and only buy when the stock was touching the orange line, returns would have been higher and the risk lower.

Considering that Nike was moderately overvalued at the beginning of 1993, and currently appears to be even more overvalued, long-term shareholder returns from buying and holding this quality stock makes sense. Shareholders would have compounded their original investment at a rate of 12.9% per annum and had their patience rewarded with an ever increasing dividend (assumed paid not reinvested) which pumps up the annualized total rate of return to 13.4% per annum.

Our next historical graph shortens the time period from 20 years to the last completed 5 years (actually five years and two months). This is important, because we discover that Nike’s long-term earnings growth rate has fallen from over 11% per annum to 8.5% per annum. On the other hand, is still strong growth considering that this includes the great recession of 2008.

But most importantly, notice that Nike started out its stock price just a smidgen below its historical PE of 18, but currently trades at a historically high PE ratio of 24. Therefore, even though we’ve had a significant slowing in Nike’s earnings growth, we simultaneously see PE expansion to the tune of 33%, from a PE of 18 to a PE of 24. This in itself is a good indication that valuation has gotten out of whack.

When you calculate Nike’s performance since December 31, 2006, we see a great example of what price earnings ratio expansion can do for shareholder returns. An earnings growth rate of only 8.5% translates into capital appreciation of 16.1%. Add in dividends, and we discover a total annual return of almost 17% per annum versus less than 1% for an equal investment in the S&P 500.

**Nike Looking to the Future: Estimated Earnings and Return Calculator**

When looking to the future, we discover that 19 analysts reporting to Capital IQ expect Nike to generate a modestly negative growth rate in earnings for fiscal 2012, ending in May, of minus 2%. Then they expect a recovery for fiscal years 2013 and 2014, before settling into an average earnings growth rate of 14%. Therefore, although there is optimism for acceleration in Nike’s future earnings growth, it should also be noted that the current PE ratio is higher than it has been in many years. Regardless, Nike appears to be overvalued both on a historical basis, and by the numbers on a forward basis.

When you translate the above estimated earnings and return calculator graph into numbers you are forced to question whether an investment in Nike shares at today’s high valuation compensates you for the risk you have to take. The current earnings yield on Nike is only 4.7%; it would take four years at the estimated growth rate for Nike’s dividend to equal what you can currently earn on the 10-year Treasury bond. Therefore, even if you’re willing to hold Nike for a long time, total return hardly seems adequate, considering the risk of either owning it or investing in it when its value is so historically high.