So what's the best way to determine if small caps are indeed overpriced? We'd all be rich if it was that easy to predict, but P/E ratios seem to be the preferred method of many a pundit. And even that one metric can be calculated in numerous ways, looking at forward earnings, trailing 12 months, and so on. No matter how you calculate it, however, P/E doesn't seem to have all that much predictive power (particularly over the short-term). At best, the Shiller P/E (which looks at average inflation-adjusted earnings over the past 10 years) correlates very little with the next year's returns. Over 10 years, the r-squared for the Shiller P/E is 0.43, still leaving a lot to be desired.

Let's just assume, for a moment, that P/E ratios

*are*valuable for making investment decisions. Looking at Morningstar forward-looking

**P/E data for iShares large, mid, and small cap ETFs**, we see:

- S&P 500 Large Cap (IVV): 17.51
- S&P 400 Mid Cap (IJH): 20.69
- S&P 600 Small Cap (IJR): 20.67

Interestingly, mid and small caps appear to be priced roughly equally based on P/E alone. If we assume all three should be roughly equal, small caps are about 18% more expensive than they should be. But that includes a lot of

*ifs*.*If*earnings grow at the same rate for all three segments, most importantly.What about other ratios? The Fama-French three-factor model uses price-to-book to determine what stocks fall into the value category. It's tough to make much of an argument for large value stocks outperforming large growth over time, but Fama-French found that the small value premium has been persistent over time. That said, let's look at

**P/B ratios for the same three ETFs:**

- S&P 500 Large Cap (IVV): 2.43
- S&P 400 Mid Cap (IJH): 2.23
- S&P 600 Small Cap (IJR): 2.02

Now small caps look significantly cheaper, with large caps appearing to be 20% more expensive. I'm not sure what P/B ratios have been historically for small and mid caps, but the S&P 500 looks reasonable based on the past 15 years or so. Perhaps goodwill is more valuable for large companies with well-known brands? I'm really not sure, but small caps don't look expensive by this measure.

Next, let's take a look at price-to-sales. P/S probably isn't all that useful to compare individual stocks. Most investors would probably much rather invest in a smaller company with huge profit margins rather than a bigger company (from a revenue standpoint) that operates on razor-thin margins. But it's a pretty interesting ratio to evaluate ETFs, when each fund holds hundreds of stocks. On average across a large sample size it might tell you something. So how about the

Next, let's take a look at price-to-sales. P/S probably isn't all that useful to compare individual stocks. Most investors would probably much rather invest in a smaller company with huge profit margins rather than a bigger company (from a revenue standpoint) that operates on razor-thin margins. But it's a pretty interesting ratio to evaluate ETFs, when each fund holds hundreds of stocks. On average across a large sample size it might tell you something. So how about the

**P/S ratios:**- S&P 500 Large Cap (IVV): 1.74
- S&P 400 Mid Cap (IJH): 1.27
- S&P 600 Small Cap (IJR): 1.16

Again we have another metric to murky the waters further, with large caps looking more expensive relative to mid and small caps. On the flip side of that,

**price/cash flow**looks more favorable to large caps (similar to P/E) with the bigger companies looking more affordable. As if that weren't confusing enough,*sales*growth rates for mid and small cap stocks are predicted to be slightly higher than large caps (about 4% vs 3%) but cash-flow and book-value growth is anticipated to be higher for large caps.In other words,

**I have no clue if small caps are overvalued relative to large caps.**The talking heads may insist upon it, but I don't believe there's enough convincing evidence to definitively suggest that companies with large market cap sizes will outperform any other cap size over the next few years. As a whole, if you believe the market P/E ratio tells you something, we're a bit on the high side in comparison to historical values. If you think the Shiller P/E is more valuable, then the market could be

*really*overpriced. But in terms of one asset class category outperforming, that seems like a gamble at best.

This is just my opinion. As always, consult a financial professional and do your own research at multiple sources before making any investment decisions.

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