Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part III. Picking Winners

IN THIS PART …

Use basic accounting and find financial information that helps you uncover value stocks that can power your prosperity.

Invest in the hottest sectors that will be growing in the coming years.

Turn your expectations into big money with motif investing, and locate small cap stocks that offer huge potential.

Know which stocks and sectors will benefit from economic and political trends.

IN THIS CHAPTER

Determining a company’s value

Using accounting principles to understand a company’s financial condition

Too often, the only number investors look at when they look at a stock is the stock’s price. Yet what determines the stock price is the company behind that single number. To make a truly good choice in the world of stocks, you have to consider the company’s financial information. What does it take to see these important numbers?

This book and a little work on your part are all you need to succeed. This chapter takes the mystery out of the numbers behind the stock. The most tried-and-true method for picking a good stock starts with picking a good company. Picking a company means looking at its products, services, industry, and financial strength. Considering the problems that the market has witnessed in recent years — such as subprime debt problems and derivative meltdowns wreaking havoc on public companies and financial firms — this chapter is more important than ever. Understanding the basics behind the numbers can save your portfolio.

Recognizing Value When You See It

If you pick a stock based on the value of the underlying company that issues it, you’re a value investor — an investor who looks at a company’s value to judge whether you can purchase the stock at a good price. Companies have value the same way many things have value, such as eggs or elephant-foot umbrella stands. And there’s a fair price to buy them at, too. Take eggs, for example. You can eat them and have a tasty treat while getting nutrition as well. But would you buy an egg for $1,000 (and no, you’re not a starving millionaire on a deserted island)? Of course not. But what if you could buy an egg for 5 cents? At that point, it has value and a good price. This kind of deal is a value investor’s dream.

Value investors analyze a company’s fundamentals (earnings, assets, net worth, and so on) to see whether the information justifies purchasing the stock. They see whether the stock price is low relative to these verifiable, quantifiable factors. Therefore, value investors use fundamental analysis, whereas other investors may use technical analysis. Technical analysis looks at stock charts and statistical data, such as trading volume and historical stock prices (I take a closer look at technical analysis for investors in Chapter 10). Some investors use a combination of both strategies.

History has shown that the most successful long-term investors have typically been value investors using fundamental analysis as their primary investing approach. The most consistently successful long-term investors were — and are — predominately value investors (yes, I count myself in this crowd as well).

In the following sections, I describe different kinds of value and explain how to spot a company’s value in several places.

Understanding different types of value

Value may seem like a murky or subjective term, but it’s the essence of good stock-picking. You can measure value in different ways (as you discover in the following sections), so you need to know the differences and understand the impact that value has on your investment decisions.

Market value

When you hear someone quoting a stock at $47 per share, that price reflects the stock’s market value. The total market valuation of a company’s stock is also referred to as its market cap or market capitalization. How do you determine a company’s market cap? With the following simple formula:

Market capitalization equals Share price multiplied by Number of shares outstanding

If Bolshevik Corp.’s stock is $35 per share and it has 10 million shares outstanding (or shares available for purchase), its market cap is $350 million. Granted, $350 million may sound like a lot of money, but Bolshevik Corp. is considered a small cap stock. (For more information about small cap stocks, dip into Chapter 14.)

Who sets the market value of stock? The market, of course! Millions of investors buying and selling directly and through intermediaries such as mutual funds determine the market value of any particular stock. If the market perceives that the company is desirable, investor demand for the company’s stock pushes up the share price.

The problem with market valuation is that it’s not always a good indicator of a good investment. In recent years, plenty of companies have had astronomical market values, yet they’ve proven to be very risky investments. For example, think about Twitter (symbol TWTR). In February 2014, its stock price was more than $67 per share. It had lots of debt and generated losses during 2014 and 2015. By January 2016, its stock price had plummeted to about $17 per share (a 75 percent plunge, erasing billions in market cap), and it still wasn’t generating a profit. Yikes! Because market value is a direct result of buying and selling by stock investors, it can be a fleeting thing. This precariousness is why investors must understand the company behind the stock price.

Book value and intrinsic value

Book value (also referred to as accounting value) looks at a company from a balance sheet perspective (assets minus liabilities equals net worth, or stockholders’ equity). It’s a way of judging a firm by its net worth to see whether the stock’s market value is reasonable compared to the company’s intrinsic value. Intrinsic value is tied to what the market price of a company’s assets — both tangible (such as equipment) and intangible (such as patents) — would be if they were sold.

Generally, market value tends to be higher than book value. If market value is substantially higher than book value, the value investor becomes more reluctant to buy that particular stock because it’s overvalued. The closer the stock’s market capitalization is to the book value, the safer the investment.

I like to be cautious with a stock whose market value is more than twice its book value. If the market value is $1 billion or more and the book value is $500 million or less, that’s a good indicator that the business may be overvalued, or valued at a higher price than its book value and ability to generate a profit. Just understand that the farther the market value is from the company’s book value, the more you’ll pay for the company’s real potential value. And the more you pay for the company’s real value, the greater the risk that the company’s market value (the stock price, that is) can decrease.

Sales value and earnings value

A company’s intrinsic value is directly tied to its ability to make money. For this reason, many analysts like to value stocks from the perspective of the company’s income statement. Two common barometers of value are expressed in ratios: the price to sales ratio (PSR) and the price-to-earnings (P/E) ratio. In both instances, the price is a reference to the company’s market value (as reflected in its share price). Sales and earnings are references to the firm’s ability to make money. I cover these two ratios more fully in the section “Tooling around with ratios,” later in this chapter.

For investors, the general approach is clear. The closer the market value is to the company’s intrinsic value, the better. And, of course, if the market value is lower than the company’s intrinsic value, you have a potential bargain worthy of a closer look. Part of looking closer means examining the company’s income statement (which I discuss later in this chapter), also called the profit and loss statement, or simply the P&L. A low price to sales ratio is 1, a medium PSR is between 1 and 2, and a high PSR is 3 or higher.

Putting the pieces together

When you look at a company from a value-oriented perspective, here are some of the most important items to consider (see the later section “Accounting for Value” for more information):

· The balance sheet, to figure out the company’s net worth: A value investor doesn’t buy a company’s stock because it’s cheap; she buys it because it’s undervalued (the company is worth more than the price its stock reflects — its market value is as close as possible to its book value).

· The income statement, to figure out the company’s profitability: A company may be undervalued from a simple comparison of the book value and the market value, but that doesn’t mean it’s a screaming buy. For example, what if you find out that a company is in trouble and losing money this year? Do you buy its stock then? No, you don’t. Why invest in the stock of a losing company? (If you do, you aren’t investing — you’re gambling or speculating.) The heart of a firm’s value, besides its net worth, is its ability to generate profit.

· Ratios that let you analyze just how well (or not so well) the company is doing: Value investors basically look for a bargain. That being the case, they generally don’t look at companies that everyone is talking about, because by that point, the stock of those companies ceases to be a bargain. The value investor searches for a stock that will eventually be discovered by the market and then watches as the stock price goes up. But before you bother digging into the fundamentals to find that bargain stock, first make sure that the company is making money.

The more ways that you can look at a company and see value, the better:

· Examine the P/E ratio. The first thing I look at is the P/E ratio. Does the company have one? (This question may sound dumb, but if the company is losing money, it may not have one.) Does the P/E ratio look reasonable or is it in triple-digit, nosebleed territory?

· Check out the debt load. Next, look at the company’s debt load (the total amount of liabilities). Is it less than the company’s equity? Are sales healthy and increasing from the prior year? Does the firm compare favorably in these categories versus other companies in the same industry?

· Think in terms of 10s. Simplicity to me is best. You’ll notice that the number 10 comes up frequently as I measure a company’s performance, juxtaposing all the numbers that you need to be aware of. If net income is rising by 10 percent or more, that’s fine. If the company is in the top 10 percent of its industry, that’s great. If the industry is growing by 10 percent or better (sales and so on), that’s terrific. If sales are up 10 percent or more from the prior year, that’s wonderful. A great company doesn’t have to have all these things going for it, but it should have as many of these things happening as possible to ensure greater potential success.

Does every company/industry have to neatly fit these criteria? No, of course not. But it doesn’t hurt you to be as picky as possible. You need to find only a handful of stocks from thousands of choices. (Hey, this approach has worked for me, my clients, and my students for more than three decades — ’nuff said.)

Value investors can find thousands of companies that have value, but they can probably buy only a handful at a truly good price. The number of stocks that can be bought at a good price is relative to the market. In mature bull markets (markets in a prolonged period of rising prices), a good price is hard to find because most stocks have probably seen significant price increases, but in bear markets (markets in a prolonged period of falling prices), good companies at bargain prices are easier to come by.

Accounting for Value

Profit is to a company what oxygen is to you and me. Without profit, a company can’t survive, much less thrive. Without profit, it can’t provide jobs, pay taxes, and invest in new products, equipment, or innovation. Without profit, the company eventually goes bankrupt, and the price of its stock plummets toward zero.

In the heady days leading up to the bear market of 2000-2002, many investors lost a lot of money simply because they invested in stocks of companies that weren’t making a profit. Lots of public companies ended up like bugs that just didn’t see the windshield coming their way. Companies such as Enron, WorldCom, and Global Crossing entered the graveyard of rather-be-forgotten stocks. Stock investors as a group lost trillions of dollars investing in glitzy companies that sounded good but weren’t making money. When their brokers were saying, “buy, buy, buy,” their hard-earned money was saying, “bye, bye, bye!” What were they thinking?

Stock investors need to pick up some rudimentary knowledge of accounting to round out their stock-picking prowess and to be sure that they’re getting a good value for their investment dollars. Accounting is the language of business. If you don’t understand basic accounting, you’ll have difficulty being a successful investor. Investing without accounting knowledge is like traveling without a map. However, if you can run a household budget, using accounting analysis to evaluate stocks is easier than you think, as you find out in the following sections.

Finding the relevant financial data on a company isn’t difficult in the age of information and 24-hour Internet access. Websites such as www.nasdaq.com can give you the most recent balance sheets and income statements of most public companies. You can find out more about public information and company research in Chapter 6.

CRASH-TEST DUMMY CANDIDATE?

From 2001-2003, consumers were buying up SUVs … uh … ASAP. Demand was very high for those popular gas-guzzling vehicles, and auto giant General Motors (GM) was racking up record sales. Investors noticed GM’s success, and its stock surpassed $76 in 2001. However, the numbers (and the times) were catching up with GM. Its zero-interest financing program started to sputter. Debts and human resource liabilities (such as employee health and retirement commitments) started accelerating. Energy costs rose, making SUVs less attractive. The red flags came out. GM’s 2004 year-end balance sheet showed debt of more than $451 billion, while total shareholder equity was only $27.7 billion. GM’s net income fell to just 1 percent of net sales, and its price-to-earnings (P/E) ratio ballooned to a lofty 39. The stock price hit $25 by April 2005. Although the price rebounded to the mid-$30s by July 2005, investors had skid marks on their portfolio as the stock lost nearly two-thirds of its value during that time frame. By September 2005, GM reported a net loss (goodbye P/E ratio). In my reckoning, GM was no longer an investment; it was a speculation.

As a contrasting point, look at Exxon Mobil (XOM) during that same time frame. Its stock price went from about $35 in early 2001 to $60 in July 2005 (it had a 2-for-1 stock split in mid-2001; in other words, investors who previously had 100 shares of stock at, say, $100 had 200 shares at $50 after the split). XOM’s net income was a healthy 8 percent of sales, and the P/E ratio was only 14. In its 2004 year-end balance sheet, total shareholder equity of $101.7 billion comfortably exceeded its total liabilities of $89.5 billion. A sound company with sound numbers. (Ya hear me?)

The point here is that the stock price ultimately reflects the financial health and vitality of the company, and you can easily find and evaluate that information. You don’t need luck or a crystal ball. Again, just a little work in the form of fundamental analysis is sufficient.

Breaking down the balance sheet

A company’s balance sheet gives you a financial snapshot of what the company looks like in terms of the following equation:

Assets minus Liabilities equals Net worth (or net equity)

In the following sections, I list the questions that a balance sheet can answer and explain how to judge a company’s strength over time from a balance sheet.

Answering a few balance sheet questions

Analyze the following items that you find on the balance sheet:

· Total assets: Have they increased from the prior year? If not, was it because of the sale of an asset or a write-off (uncollectable accounts receivable, for example)?

· Financial assets: In recent years, many companies (especially banks and brokerage firms) had questionable financial assets (such as subprime mortgages and specialized bonds) that went bad, and they had to write them off as unrecoverable losses. Does the company you’re analyzing have a large exposure to financial assets that are low-quality (and hence, risky) debt?

· Inventory: Is inventory higher or lower than last year? If sales are flat but inventory is growing, that may be a problem.

· Debt: Debt is the biggest weakness on the corporate balance sheet. Make sure that debt isn’t a growing item and that it’s under control. In recent years, debt has become a huge problem.

· Derivatives: A derivative is a speculative and complex financial instrument that doesn’t constitute ownership of an asset (such as a stock, bond, or commodity) but is a promise to convey ownership. Some derivatives are quite acceptable because they’re used as protective or hedging vehicles (this use isn’t my primary concern). However, they’re frequently used to generate income and can then carry risks that can increase liabilities. Standard options and futures are examples of derivatives on a regulated exchange, but the derivatives I’m talking about here are a different animal and in an unregulated part of the financial world. They have a book value exceeding $600 trillion and can easily devastate a company, sector, or market (as the credit crisis of 2008 showed).

Find out whether the company dabbles in these complicated, dicey, leveraged financial instruments. Find out (from the company’s 10K report; see Chapter 12) whether it has derivatives and, if so, the total amount. Having derivatives that are valued higher than the company’s net equity may cause tremendous problems. Derivatives problems sank many organizations ranging from stodgy banks (Barings Bank of England) to affluent counties (Orange County, California) to once-respected hedge funds (LTCM) to infamous corporations (Enron in 2001 and Glencore in 2015).

· Equity: Equity is the company’s net worth (what’s left in the event that all the assets are used to pay off all the company debts). The stockholders’ equity should be increasing steadily by at least 10 percent per year. If not, find out why.

Table 11-1 shows you a brief example of a balance sheet.

Table 11-1 XYZ Balance Sheet — December 31, 2015

By looking at a company’s balance sheet, you can address the following questions:

· What does the company own (assets)? The company can own assets, which can be financial, tangible, and/or intangible. An asset is anything that has value or that can be converted to or sold for cash. Financial assets can be cash, investments (such as stocks or bonds of other companies), or accounts receivable. Assets can be tangible items such as inventory, equipment, and/or buildings. They can also be intangible things such as licenses, trademarks, or copyrights.

· What does the company owe (liabilities)? A liability is anything of value that the company must ultimately pay someone else for. Liabilities can be invoices (accounts payable) or short-term or long-term debt.

· What is the company’s net equity (net worth)? After you subtract the liabilities from the assets, the remainder is called net worth, net equity, or net stockholders’ equity. This number is critical when calculating a company’s book value.

Assessing a company’s financial strength over time

The logic behind the assets/liabilities relationship of a company is the same as that of your own household. When you look at a snapshot of your own finances (your personal balance sheet), how can you tell whether you’re doing well? Odds are that you start by comparing some numbers. If your net worth is $5,000, you may say, “That’s great!” But a more appropriate remark is something like, “That’s great compared to, say, a year ago.”

Compare a company’s balance sheet at a recent point in time to a past time. You should do this comparative analysis with all the key items on the balance sheet, which I list in the preceding section, to see the company’s progress (or lack thereof). Is it growing its assets and/or shrinking its debt? Most important, is the company’s net worth growing? Has it grown by at least 10 percent since a year ago? All too often, investors stop doing their homework after they make an initial investment. You should continue to look at the firm’s numbers regularly so that you can be ahead of the curve. If the business starts having problems, you can get out before the rest of the market starts getting out (which causes the stock price to fall).

To judge the financial strength of a company, ask yourself the following questions:

· Are the company’s assets greater in value than they were three months ago, a year ago, or two years ago? Compare current asset size to the most recent two years to make sure that the company is growing in size and financial strength.

· How do the individual items compare with prior periods? Some particular assets that you want to take note of are cash, inventory, and accounts receivable.

· Are liabilities such as accounts payable and debt about the same, lower, or higher compared to prior periods? Are they growing at a similar, faster, or slower rate than the company’s assets? Debt that rises faster and higher than items on the other side of the balance sheet is a warning sign of pending financial problems.

· Is the company’s net worth or equity greater than the preceding year? And is that year’s equity greater than the year before? In a healthy company, the net worth is constantly rising. As a general rule, in good economic times, net worth should be at least 10 percent higher than the preceding year. In tough economic times (such as a recession), 5 percent is acceptable. Seeing the net worth grow at a rate of 15 percent or higher is great.

Looking at the income statement

Where do you look if you want to find out what a company’s profit is? Check out the firm’s income statement. It reports, in detail, a simple accounting equation that you probably already know:

Sales minus Expenses equals Net profit (or net earnings, or net income)

Look at the following figures found on the income statement:

· Sales: Are they increasing? If not, why not? By what percentage are sales increasing? Preferably, they should be 10 percent higher than the year before. Sales are, after all, where the money comes from to pay for all the company’s activities (such as expenses) and create subsequent profits.

· Expenses: Do you see any unusual items? Are total expenses reported higher than the prior year, and if so, by how much? If the total is significantly higher, why? A company with large, rising expenses will see profits suffer, which isn’t good for the stock price.

· Research and development (R&D): How much is the company spending on R&D? Companies that rely on new product development (such as pharmaceuticals or biotech firms) should spend at least as much as they did the year before (preferably more) because new products mean future earnings and growth.

· Earnings: This figure reflects the bottom line. Are total earnings higher than the year before? How about earnings from operations (leaving out expenses such as taxes and interest)? The earnings section is the heart and soul of the income statement and of the company itself. Out of all the numbers in the financial statements, earnings have the greatest single impact on the company’s stock price.

Table 11-2 shows you a brief example of an income statement.

Table 11-2 XYZ Income Statement for Year Ending 12/31/2015

Looking at the income statement, an investor can try to answer the following questions:

· What sales did the company make? Businesses sell products and services that generate revenue (known as sales or gross sales). Sales also are referred to as the top line.

· What expenses did the company incur? In generating sales, companies pay expenses such as payroll, utilities, advertising, administration, and so on.

· What is the net profit? Also called net earnings or net income, net profit is the bottom line. After paying for all expenses, what profit did the company make?

The information you glean should give you a strong idea about a firm’s current financial strength and whether it’s successfully increasing sales, holding down expenses, and ultimately maintaining profitability. You can find out more about sales, expenses, and profits in the sections that follow.

Sales

Sales refers to the money that a company receives as customers buy its goods and/or services. It’s a simple item on the income statement and a useful number to look at. Analyzing a business by looking at its sales is called top line analysis.

As an investor, you should take into consideration the following points about sales:

· Sales should be increasing. A healthy, growing company has growing sales. They should grow at least 10 percent from the prior year, and you should look at the most recent three years.

· Core sales (sales of those products or services that the company specializes in) should be increasing. Frequently, the sales figure has a lot of stuff lumped into it. Maybe the company sells widgets (what the heck is a widget, anyway?), but the core sales shouldn’t include other things, such as the sale of a building or other unusual items. Take a close look. Isolate the firm’s primary offerings and ask whether these sales are growing at a reasonable rate (such as 10 percent).

· Does the company have odd items or odd ways of calculating sales? In the late 1990s, many companies boosted their sales by aggressively offering affordable financing with easy repayment terms. Say you find out that Suspicious Sales Inc. (SSI) had annual sales of $50 million, reflecting a 25 percent increase from the year before. Looks great! But what if you find out that $20 million of that sales number comes from sales made on credit that the company extended to buyers? Some companies that use this approach later have to write off losses as uncollectable debt because the customers ultimately can’t pay for the goods.

If you want to get a good clue as to whether a company is artificially boosting sales, check its accounts receivable (listed in the asset section of its balance sheet). Accounts receivable refers to money that is owed to the company for goods that customers have purchased on credit. If you find out that sales went up by $10 million (great!) but accounts receivable went up by $20 million (uh-oh), something just isn’t right. That may be a sign that the financing terms were too easy, and the company may have a problem collecting payment (especially in a recession).

Expenses

How much a company spends has a direct relationship to its profitability. If spending isn’t controlled or held at a sustainable level, it may spell trouble for the business.

When you look at a company’s expense items, consider the following:

· Compare expense items to the prior period. Are expenses higher than, lower than, or about the same as those from the prior period? If the difference is significant, you should see commensurate benefits elsewhere. In other words, if overall expenses are 10 percent higher compared to the prior period, are sales at least 10 percent more during the same period?

· Are some expenses too high? Look at the individual expense items. Are they significantly higher than the year before? If so, why?

· Have any unusual items been expensed? An unusual expense isn’t necessarily a negative. Expenses may be higher than usual if a company writes off uncollectable accounts receivable as a bad debt expense. Doing so inflates the total expenses and subsequently results in lower earnings. Pay attention to nonrecurring charges that show up on the income statement and determine whether they make sense.

Profit

Earnings or profit is the single most important item on the income statement. It’s also the one that receives the most attention in the financial media. When a company makes a profit, it’s usually reported as earnings per share (EPS). So if you hear that XYZ Corporation (yes, the infamous XYZ Corp.!) beat last quarter’s earnings by a penny, here’s how to translate that news. Suppose that the company made $1 per share this quarter and 99 cents per share last quarter. If that company had 100 million shares of stock outstanding, its profit this quarter is $100 million (the EPS times the number of shares outstanding), which is $1 million more than it made in the prior quarter ($1 million is 1 cent per share times 100 million shares).

Don’t simply look at current earnings as an isolated figure. Always compare current earnings to earnings in past periods (usually a year). For example, if you’re looking at a retailer’s fourth-quarter results, don’t compare them with the retailer’s third-quarter outcome. Doing so is like comparing apples to oranges. What if the company usually does well during the December holidays but poorly in the fall? In that case, you don’t get a fair comparison.

A strong company should show consistent earnings growth from the period before (such as the prior year or the same quarter from the prior year), and you should check the period before that, too, so that you can determine whether earnings are consistently rising over time. Earnings growth is an important barometer of the company’s potential growth and bodes well for the stock price.

When you look at earnings, here are some things to consider:

· Total earnings: This item is the most watched. Total earnings should grow year to year by at least 10 percent.

· Operational earnings: Break down the total earnings and look at a key subset — that portion of earnings derived from the company’s core activity. Is the company continuing to make money from its primary goods and services?

· Nonrecurring items: Are earnings higher (or lower) than usual or than expected, and if so, why? Frequently, the difference results from items such as the sale of an asset or a large depreciation write-off.

I like to keep percentages as simple as possible. Ten percent is a good number because it’s easy to calculate and it’s a good benchmark. However, 5 percent isn’t unacceptable if you’re talking about tough times, such as a recession. Obviously, if sales, earnings, and/or net worth are hitting or surpassing 15 percent, that’s great.

Tooling around with ratios

A ratio is a helpful numerical tool that you can use to find out the relationship between two or more figures found in a company’s financial data. A ratio can add meaning to a number or put it in perspective. Ratios sound complicated, but they’re easier to understand than you may think.

Say that you’re considering a stock investment and the company you’re looking at has earnings of $1 million this year. You may think that’s a nice profit, but in order for this amount to be meaningful, you have to compare it to something. What if you find out that the other companies in the industry (of similar size and scope) had earnings of $500 million? Does that change your thinking? Or what if the same company had earnings of $75 million in the prior period? Does that change your mind?

Two key ratios to be aware of are

· Price-to-earnings (P/E) ratio

· Price to sales ratio (PSR)

Every investor wants to find stocks that have a 20 percent average growth rate over the past five years and have a low P/E ratio (sounds like a dream). Use stock screening tools available for free on the Internet to do your research. A stock screening tool lets you plug in numbers, such as sales or earnings, and ratios, such as the P/E ratio or the debt to equity ratio, and then click! — up come stocks that fit your criteria. These tools are a good starting point for serious investors. Many brokers have them at their websites (such as Charles Schwab at www.schwab.com and E*TRADE at www.etrade.com). You can also find some excellent stock screening tools at Yahoo! Finance (finance.yahoo.com), Bloomberg (www.bloomberg.com), Nasdaq (www.nasdaq.com), and MarketWatch (www.marketwatch.com). Check out Appendix B for even more on ratios.

The P/E ratio

The price-to-earnings (P/E) ratio is very important in analyzing a potential stock investment because it’s one of the most widely regarded barometers of a company’s value, and it’s usually reported along with the company’s stock price in the financial page listing. The major significance of the P/E ratio is that it establishes a direct relationship between the bottom line of a company’s operations — the earnings (or net profit) — and the stock price.

The P in P/E stands for the stock’s current price. The E is for earnings per share (typically the most recent 12 months of earnings). The P/E ratio is also referred to as the earnings multiple or just multiple.

You calculate the P/E ratio by dividing the price of the stock by the earnings per share. If the price of a single share of stock is $10 and the earnings (on a per-share basis) are $1, then the P/E is 10. If the stock price goes to $35 per share and the earnings are unchanged, then the P/E is 35. Basically, the higher the P/E, the more you pay for the company’s earnings.

Why would you buy stock in one company with a relatively high P/E ratio instead of investing in another company with a lower P/E ratio? Keep in mind that investors buy stocks based on expectations. They may bid up the price of the stock (subsequently raising the stock’s P/E ratio) because they feel that the company will have increased earnings in the near future. Perhaps they feel that the company has great potential (a pending new invention or lucrative business deal) that will eventually make it more profitable. More profitability in turn has a beneficial impact on the firm’s stock price. The danger with a high P/E is that if the company doesn’t achieve the hoped-for results, the stock price can fall.

You should look at two types of P/E ratios to get a balanced picture of the company’s value:

· Trailing P/E: This P/E is the most frequently quoted because it deals with existing data. The trailing P/E uses the most recent 12 months of earnings in its calculation.

· Forward P/E: This P/E is based on projections or expectations of earnings in the coming 12-month period. Although this P/E may seem preferable because it looks into the near future, it’s still considered an estimate that may or may not prove to be accurate.

The following example illustrates the importance of the P/E ratio. Say that you want to buy a business and I’m selling a business. You come to me and say, “What do you have to offer?” I say, “Have I got a deal for you! I operate a retail business downtown that sells spatulas. The business nets a cool $2,000 profit per year.” You reluctantly say, “Uh, okay, what’s the asking price for the business?” I reply, “You can have it for only $1 million! What do you say?”

If you’re sane, odds are that you politely turn down that offer. Even though the business is profitable (a cool $2,000 a year), you’d be crazy to pay a million bucks for it. In other words, the business is way overvalued (too expensive for what you’re getting in return for your investment dollars). The million dollars would generate a better rate of return elsewhere and probably with less risk. As for the business, the P/E ratio of 500 ($1 million divided by $2,000) is outrageous. This is definitely a case of an overvalued company — and a lousy investment.

What if I offered the business for $12,000? Does that price make more sense? Yes. The P/E ratio is a more reasonable 6 ($12,000 divided by $2,000). In other words, the business pays for itself in about 6 years (versus 500 years in the prior example).

Looking at the P/E ratio offers a shortcut for investors asking the question, “Is this stock overvalued?” As a general rule, the lower the P/E, the safer (or more conservative) the stock is. The reverse is more noteworthy: The higher the P/E, the greater the risk.

When someone refers to a P/E as high or low, you have to ask the question, “Compared to what?” A P/E of 30 is considered very high for a large cap electric utility but quite reasonable for a small cap, high-technology firm. Keep in mind that phrases such as large cap and small cap are just a reference to the company’s market value or size (see Chapter 1 for details on these terms). Cap is short for capitalization (the total number of shares of stock outstanding multiplied by the share price).

The following basic points can help you evaluate P/E ratios:

· Compare a company’s P/E ratio with its industry. Electric utility industry stocks, for example, generally have a P/E that hovers in the 9-14 range. Therefore, an electric utility with a P/E of 45 indicates that something is wrong with that utility. (I touch on sectors and industries in Chapter 13.)

· Compare a company’s P/E with the general market. If you’re looking at a small cap stock on the Nasdaq that has a P/E of 100 and the average P/E for established companies on the Nasdaq is 40, find out why. You should also compare the stock’s P/E ratio with the P/E ratio for major indexes such as the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 (S&P 500), and the Nasdaq Composite. Stock indexes are useful for getting the big picture, and I include them in Chapter 5 and Appendix A.

· Compare a company’s current P/E with recent periods (such as this year versus last year). If it currently has a P/E ratio of 20 and it previously had a P/E ratio of 30, you know that either the stock price has declined or that earnings have risen. In this case, the stock is less likely to fall. That bodes well for the stock.

· Low P/E ratios aren’t necessarily a sign of a bargain, but if you’re looking at a stock for many other reasons that seem positive (solid sales, strong industry, and so on) and it also has a low P/E, that’s a good sign.

· High P/E ratios aren’t necessarily bad, but they do mean that you should investigate further. If a company is weak and the industry is shaky, heed the high P/E as a warning sign. Frequently, a high P/E ratio means that investors have bid up a stock price, anticipating future income. The problem is that if the anticipated income doesn’t materialize, the stock price can fall.

· Watch out for a stock that doesn’t have a P/E ratio. In other words, it may have a price (the P), but it doesn’t have earnings (the E). No earnings means no P/E, meaning that you’re better off avoiding the stock. Can you still make money buying a stock with no earnings? You can, but you aren’t investing; you’re speculating.

The PSR

The price to sales ratio (PSR) is a company’s stock price divided by its sales. Because the sales number is rarely expressed as a per-share figure, it’s easier to divide a company’s total market value (I explain market value earlier in this chapter) by its total sales for the last 12 months.

As a general rule, stock trading at a PSR of 1 or less is a reasonably priced stock worthy of your attention. For example, say that a company has sales of $1 billion and the stock has a total market value of $950 million. In that case, the PSR is 0.95. In other words, you can buy $1 of the company’s sales for only 95 cents. All things being equal, that stock may be a bargain.

Analysts frequently use the PSR as an evaluation tool in the following circumstances:

· In tandem with other ratios to get a more well-rounded picture of the company and the stock.

· When they want an alternative way to value a business that doesn’t have earnings.

· When they want a true picture of the company’s financial health, because sales are tougher for companies to manipulate than earnings.

· When they’re considering a company offering products (versus services). PSR is more suitable for companies that sell items that are easily counted (such as products). Firms that make their money through loans, such as banks, aren’t usually valued with a PSR because deriving a usable PSR for them is more difficult.

Compare the company’s PSR with other companies in the same industry, along with the industry average, so that you get a better idea of the company’s relative value.