The S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) closed Friday on a price-to-earnings (PE) ratio of 16.47, down from a PE of 17.18 on 28 of May but still well above the long-term historical average PE, which is closer to 15. While the PE will always fluctuate and at times deserves to trade above its long-term historical average, investors need to consider, given the current economic outlook, whether now is one of those times?
It's not just the Australian market which is looking like it might be overvalued either. The US market, using the more accurate Shiller PE, which is a measure created by Professor Robert Shiller of the PE ratio adjusted for market cycles, is currently at 23.4 placing it significantly above the long-term average of 16.5.
With a number of index constituents trading on high forecast PEs such as Aristocrat Leisure (ASX: ALL) on 23 times, Carsales.com (ASX: CRZ) on 25.7 times and Ramsay Healthcare (ASX: RHC) on 25.9 times, investors need to remember to keep their valuations in perspective.
Foolish takeaway
While many companies have better than average growth profiles and therefore premium ratings are justified, when the whole market it overvalued, history shows that investors can begin to stray too far from sensible valuations.
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Motley Fool contributor Tim McArthur has no financial interest in any company mentioned in this article.
