Investors closely follow the price-earnings, or P-E, ratio of their favorite stocks. Low P-E ratios are usually considered a buy signal since it shows that a dollar of earnings is selling at a relatively inexpensive price.
For example, for a $10 stock, $1 of earnings per share equates to a P-E ratio of 10; while that same stock with only 50 cents of earnings would be trading at a P-E ratio of 20. The lower ratio represents the greater value, if everything else is equal, which it never is. However, the P-E ratio offers a rough guide to value.
A P-E ratio for home prices can be calculated by dividing the average annual rent by the average sales price of a home. These numbers are easily obtained from government reports. Right now, they show that homes have a P-E ratio of 20. This is the average value of the past 50 years.
Before 1999, the P-E ratio of housing was fairly stable, usually fluctuating between 18 and 20. The all-time low in this measure was 16. That value was reached as home prices fell in the early 1970s while rent increased.
Just as in the stock market, high P-E ratios often precede bear markets. We saw the all-time high P-E in 2006, when the value reached 32. Home prices peaked a year later.
If current trends in rent stay steady, to reach a new all-time low, home prices would need to fall another 14 percent.
It’s more likely rents will increase slightly, and the most likely scenario is that home prices are within 2 percent to 5 percent of a bottom, at the national level.
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