Are Stocks Overvalued? 5 Indicators to Watch

Market valuation tools attempt to answer a seemingly simple question: Are stocks overvalued? Each metric approaches this puzzle from a different angle. Many tools directly compare stock prices to corporate earnings or net assets—like the common price-to-earnings (P/E) and price-to-book (P/B) ratios. Others attempt to measure the value of stocks versus economic output, or position earnings against inflation.

Ultimately, none of these tools can accurately predict where the market is headed next or help investors precisely time market entries and exits. And it's worth repeating that research shows market timing may often be a fool's errand. However, valuation metrics can provide a way to gauge whether stocks reflect durable fundamentals in a wider historical context or if investor optimism has potentially run ahead of reality.

With this in mind, let's examine five widely followed market valuation tools to see what each can—and, perhaps more importantly, can't—tell investors.

The Nobel Prize-winning Yale economist Robert Shiller famously developed the cyclically adjusted price-to-earnings, or CAPE, ratio in 1988 alongside John Campbell, who is now a Harvard economics professor. The valuation metric divides a stock's (or index's) current price by its 10-year average of inflation-adjusted earnings per share (EPS).

The Shiller CAPE ratio is typically used to value the S&P 500^® index (SPX) and is lauded for its ability to smooth out earnings fluctuations caused by business cycles and recessions, which some argue may provide a more stable, long-term view of market valuations. A "high" Shiller CAPE ratio—anything significantly above its long-run average of roughly 17—indicates the broad market may be overvalued, while a low reading suggests the market may be undervalued.

While the predictive power of any market valuation metric is questionable, the Shiller CAPE ratio has proven its value in the past. During the dot-com bubble of the late 1990s, for example, it reached record highs, warning investors that stocks were likely overvalued. This history has caused many analysts and investors to praise the metric. Still, like all valuation tools, the Shiller CAPE ratio has faced its fair share of criticism.

A primary criticism of the CAPE ratio is the metric's backward-looking nature due to its use of average inflation-adjusted EPS over a 10-year period. Critics argue that measuring the market's current valuation using earnings from the past decade fails to account for earnings growth that is likely to occur moving forward.

The CAPE ratio also doesn't account for stock buybacks, which have become an increasingly popular way to return cash to shareholders. And its use of Generally Accepted Accounting Principles (GAAP) earnings—which have changed over time due to new GAAP standards—can create challenges when comparing current Shiller CAPE ratios to historical data.

Named after Berkshire Hathaway's Warren Buffett, the Buffett indicator divides the total value of all publicly traded stocks in a country by that country's gross domestic product (GDP). Interestingly, this indicator was also developed by Yale's Shiller but popularized by Buffett in 2001 after he told Fortune it was "probably the best single measure of where valuations stand at any given moment."

A reading above 100% for this indicator is typically considered a signal that the market may be overvalued, while a reading below that level suggests it may be undervalued. However, some market watchers argue the overvaluation threshold level should be set higher at 120%.

Much like the Shiller CAPE ratio, the Buffett Indicator reached historical highs before the dot-com bubble burst in 2000. But the indicator hasn't always been so prescient. Like other valuation metrics, it's remained well above the overvaluation threshold for many years during past bull markets, demonstrating the potential issue with using valuations as market-timing tools.

The main critique of the Buffet Indicator is that stock market valuations are based, in part, on revenues and earnings derived from international activity, while GDP only considers domestic economic output. This can skew the indicator's valuation of markets, particularly in countries where many domestic companies rely on international revenues. In the United States, for example, 28% of S&P 500 revenues came from foreign sales in 2024, according to Goldman Sachs.

Other opponents of the Buffett Indicator argue that GDP may not fully account for economic shifts, including new innovations that have made the U.S. economy more service-oriented. Because GDP struggles to capture the quality and value provided by many modern digital services, they claim the Buffett Indicator may be a less reliable tool for valuing stocks.

The Rule of 20 suggests the sum of the stock market's P/E ratio and the inflation rate should be roughly 20 for the market to be considered fairly valued. A sum greater than 20 indicates the market may be overvalued, while a sum less than 20 suggests it could be undervalued.

Developed over 30 years ago by James Moltz of C.J. Lawrence, the Rule of 20 is now commonly used to value the S&P 500 and other broad market indexes. It's prized by many analysts and wealth managers because it factors in inflation, which can erode the value of corporate earnings. The metric also provides an easy way for investors to do a quick risk assessment on equity markets.

Critics of the Rule of 20 note that it doesn't distinguish between different types of inflation, which may have different impacts on corporate earnings. Inflation driven by strong economic growth, for example, can support earnings growth, while inflation created by supply shocks may hinder earnings growth.

The Rule of 20 was also created at a time when corporate profit margins, S&P 500 sector composition, and monetary policy were far different from what they are today. Some argue this may make it less reliable for valuing today's markets.

Often called the Q ratio, Tobin's Q divides a company's or index's market value by the cost to replace its assets. When the Q ratio is greater than 1, it suggests a company or index may be overvalued, while a Q ratio less than 1 indicates it may be undervalued. The cost to replace a company's or index's assets in Tobin's Q is commonly represented by book value, or total assets minus total liabilities.

Tobin's Q was popularized by Nobel prize-winning Yale economist James Tobin, but the ratio was first introduced in a 1966 paper by British economist Nicholas Kaldor and originally called Kaldor's V.

While Tobin's Q has become a common market valuation metric, it was originally used to evaluate corporate investment policy. The theory was that whenever a company's Q ratio exceeded 1—suggesting the market value of its assets was greater than their replacement cost— it should invest in expansion. This could mean building new factories, purchasing machinery, or spending on research and development. When the Q ratio fell below 1, however, it was seen as a signal to buy existing, undervalued companies or assets already on the market rather than build new, potentially "undervalued" assets.

One of the main critiques of Tobin's Q is that it relies on measuring replacement costs to value markets. This creates challenges because many modern companies have intangible assets that are subjectively valued, including patents, brand names, and human capital, making these replacement costs difficult to calculate.

Different inflationary environments also tend to skew Q ratios. For example, when inflation is high, the cost to replace a company's assets will be higher than normal. Additionally, Tobin's Q has an inconsistent track record of valuing the broader market. It was, however, near historical highs during the dot-com bubble, and the Q ratios of many banks were elevated prior to the Global Financial Crisis of 2008.

Popularized by economist Ed Yardeni but first published in a graph in the Fed's 1997 Humphrey-Hawkins Report, the Fed Model compares the forward earnings yield of the stock market to the current nominal yield of the 10-year Treasury note yield.

If the stock market's earnings yield is greater than the 10-year Treasury note yield, the Fed Model is considered bullish, and when the earnings yield is lower than the Treasury note yield, it's considered bearish. Proponents of this model argue that stocks and bonds are competing assets, which means investors should prefer stocks when stock yields are higher than bond yields, and vice versa.

The Fed Model offers a quick way to assess which asset class is offering a better return. It's similar to equity risk premium, another common valuation metric used by market watchers that measures the excess return investors expect to get for investing in stocks compared to so-called "risk-free" assets like Treasuries.

Critics of the Fed Model argue that its like-for-like comparison of stocks' earnings yield and the 10-year Treasury note yield is flawed because earnings aren't fully returned to shareholders like bond coupons. Like other valuation metrics, the Fed Model also fails to consider stock buybacks, which can potentially boost stocks' earnings yield.

Other opponents of the Fed Model note that it doesn't account for inflation or earnings growth. Combined, these issues make the Fed Model imperfect in their view. Historically, the Fed Model's predictive power has also been inconsistent.

It's important to remember that no market valuation tool is perfect. Each metric has flaws and limitations that investors should take into account. Using valuation tools to attempt to pinpoint market turning points and invest accordingly is also usually unwise. History shows that trying to jump in and out of the market due to valuation concerns can lead long-term investors to miss out on gains, and it typically makes more sense to stay the course.