Think of analyzing a stock as betting on a baseball game. You could just pick your favorite team, but it would probably be a better bet if you knew how your team (stock) had done in its last game against the same team. It would be an even better bet if you knew how your team had played the whole season leading up to that game. You could learn who is playing on the team (the fund managers), what the weather’s going to be like (market conditions), and who has the home field advantage (how the stock performed in this type of market before). At some point, however, the sheer amount of numerical information, from comparative batting averages of individual team members to the laws of probability, would become unmanageable for anyone save maybe a statistician or bookie.

Stock is no different. You will need to at least become familiar with the following indicators of stock health, but information above and beyond this probably isn’t necessary to an individual investor:

• Price/earnings ratio

• Earnings per share

• Current/dividend yield

• Current and debt ratios

• Book value

• Credit ratings

The Price/Earnings Ratio

The price/earnings ratio is a measurement of how much income the investor can expect from the initial investment. It is measured by dividing the price of the stock by the amount of money the stock issued (or is expected to issue) in dividends over a 12-month period:

Current Market Price of Stock: $10

÷Earnings over 12-Month Period: $1

= Price/Earnings Ratio: 10

Thus, $10 ÷ $1 = 10.

The current market price of the stock is the amount for which the stock is currently trading. In the preceding example, to buy a share of that stock today would cost $10. The earnings are the total of the dividends paid by the stock over a 12-month period. Since dividends are usually paid quarterly, in the same example we know that the total of the four dividend payments was $1. (Let’s say that the dividend was $.25 each quarter: .25 + .25 + .25 + .25 = $1.00.) Finally, although in theory you are free to choose any 12-month period you like, there are three 12-month periods that are used most and are generally accepted as providing the best representation of the stock’s past performance and future potential. They are described in the next three sections.

The Trailing P/E Ratio

The trailing P/E ratio uses the dividends of the four quarters of the previous year, regardless of when in the current year the ratio is determined. For example, on January 1, 2000, you would use the dividend payments of the four quarters of 1999 to determine the trailing P/E ratio. On December 31, 2000, you would still use the dividend payment of the four quarters of 1999 to determine the P/E ratio. For that reason, the trailing P/E ratio is most heavily affected by the price of the stock. Because the sum of the four quarters of 1999 never changes, all volatility in the trailing P/E ratio would be as a result of the change in the price of the stock. Comparing the P/E ratio at the end of the year to the P/E ratio at the beginning of the year will indicate whether the quality of the stock’s P/E ratio is improving or declining.

The Standard P/E Ratio

The standard P/E ratio, or simply the P/E ratio, is the most commonly used ratio, since it provides the most up-to-date, and therefore the most accurate, picture of the stock’s current P/E ratio. The (standard) P/E ratio is determined by using the dividends of the last four quarters. For example, if you were determining the P/E ratio on January 1, 2000, you would use the four quarters of 1999. If you were determining the P/E ratio on December 31, 2000, however, you would use the three previous quarters of 2000 and the final quarter of 1999. Because the sum of the previous four quarters would change, as would the daily price of the stock, this P/E ratio is the most volatile, but it is that volatility which enables this P/E ratio to adapt more quickly and thereby to more accurately reflect the health of the stock at that moment.

The Forward P/E Ratio

The forward P/E ratio uses the dividends of the previous two quarters and the projected earnings for the next two quarters. For example, if you were determining the P/E ratio on January 1, 2000, you would add the total of the dividends paid in the final two quarters of 1999 and then add what the company believed it would be paying out in the first two quarters of 2000. The projected earnings are used to give a better idea of how the stock’s P/E ratio is expected to perform. The use of the trailing two quarters keeps the forward P/E ratio reasonable. A company is going to have a hard time convincing investors that the stock will pay $10 in dividends in the next two quarters if the last two quarters showed dividends of only $1 per share. However, since no one can predict for certain how the stock really will do, the forward P/E ratio gives the least accurate picture of the stock.

Interpreting the P/E Ratio

Now that you know the parts that determine the P/E ratio, what does it measure in real terms? Think of it this way: Say you want to buy a store. You find both a clothing store and a convenience store for sale. To buy the clothing store will cost you $1,000, and you know that the store generates $100 in profits per year. The convenience store will cost you $2,000 but will generate $250 per year in profit. The clothing store will generate $1 in profit for every $10 of your investment. The convenience store, however, will make $1 for every $8 you put into it (1,000 ÷ 100 = 10:1 versus 2,500 ÷ 200 = 8:1). While the convenience store is more expensive, it is obviously a better investment. Stocks work on the same principle in that a P/E ratio doesn’t concern itself with how much or how little a stock costs, but rather with what kind of return you can expect for the investment—in other words, how much bang-for-your-buck potential.

As a very general rule, normal P/Es average between 10 and 20 times earnings. This rule will disappear quickly as you look at today’s stock markets. Computer companies that are expected to continue to grow are carrying P/E loads of up to 100 times earnings today and are still considered valuable investments. Anything over 20 times earning is still considered a “high P/E ratio,” however, regardless of whether the high ratio can be justified or not. High P/E ratios are therefore generally considered to be the terrain of growth companies and companies with the potential for currently unrealized gains.

Anything under 10 is considered a “low P/E ratio.” These are usually considered the territory of those big, established blue chip companies, or a company that for whatever reason isn’t expected to grow very much. Like anything else subject to risk and return, these big, established companies might not deliver the highest bang for the buck. However, the security of the investment may be more important to the investor than the potential for growth offered by a stock with a higher P/E.

Earnings per Share

Earnings per share, or EPS, is a fancy financial way of saying “divided amounts.” The total amount of a company’s net earnings divided by the number of outstanding common shares is the earnings per share. The EPS determines the stock’s dividends in dollars and cents.

The EPS is determined by adding up the number of dividends paid over a specific period of time, usually a year or four quarters, or simply the amount paid in one particular dividend payment. For all its simplicity, however, the earnings per share is hands-down the most popular measure of a stock’s health. Its simplicity makes the EPS easy to understand and makes it a straightforward indicator of the stock’s performance.

In addition to having the flexibility to determine a stock’s performance over varying time frames, the resulting EPS can be used any number of ways to determine a stock’s health. Three of the most common follow:

1. The EPS of one stock can be compared with the EPS of another stock for the same period. Say you want to invest in AT&T. It would probably be a good move to check out the EPS of other similar stocks, such as MCI or Sprint, to get a better idea of how AT&T has performed within the industry.
2. The EPS of a stock can be compared with itself over a different time frame. Comparing your stock’s current EPS with its EPS for the same quarter of the previous year will give you a better idea of the stock’s growth or decline over a longer period. This method is therefore more often used for stock that will potentially be held long term.
3. A stock’s EPS can be charted over a designated time frame. Comparing the EPS of a stock over the previous four quarters, for example, will highlight changes in the stock’s performance and enable you to determine ongoing trends. This type of information can be used to anticipate quick or systematic gains or losses in the next period or quarter.

As a final note on the earnings per share, be aware that it is all too easy to mistake the movements of the EPS as Up = good, Down = bad. This is not always the case. The EPS can rise or fall for any number of reasons other than growth in the company.

For example, since the EPS is determined by dividing all the money allotted for dividend payments by the number of common shares outstanding, a company can raise its EPS by reducing the amount of stock outstanding. The resultant rise of the EPS then creates a deceptive picture of the stock’s growth. This is a common occurrence with companies that are buying back their own stock.

For that same reason, an EPS might decline while the overall financial health of the company was improving. An EPS might drop, for example, because of a stock split, because the company converted its outstanding bonds and/or preferred stock, or because the company issued rights or warrants. In each of these cases, the EPS of the company would drop independently of the real financial condition of the company.

It is important, then, to remember that although an EPS is a relatively simple tool for measuring a company’s growth potential and financial health, that same simplicity offers other investors and companies the option to use different numbers to determine an EPS. Be sure you are all reading from the same page.

Current/Dividend Yield

The current or dividend yield indicates the percentage represented by the annual dividend payments relative to price of the stock. In other words, how much money did you make from your investment (your investment being the stock you purchased)? If this type of measurement is sounding vaguely familiar, that is because the current yield is the exact opposite of the P/E ratio. In fact, the formula to determine the current yield is to flip the P/E ratio formula upside down:

Earnings over 12-Month Period: $1

Current Market Price of Stock: $10

= Current Yield: .10%

Thus, $1 ÷ $10 = .10.

Stocks with high current yields are typically large blue chip stocks, or other stocks with limited growth potential, making them particularly attractive to investors looking for steady income streams from their stock. Since these companies have limited growth potential, most of their profits are paid out to their investors, rather than being reinvested in the company for such things as expansion or research and development. Stocks with low current yields are usually reinvesting their profits, leaving little if anything to pay out to their investors. Logically, then, low current yields are the terrain of growth stocks, which an investor would purchase for anticipated capital growth rather than a steady income stream.

It is important, as with any measurement, to ensure that you know the baseline from which the measurement is being generated. Simply because a current yield is high or low is not an absolute indicator of anything. Remember that the current yield formula is totally dependent on the amount of dividends paid and that amount is the arbitrary decision of a company’s management. That’s right; no company is obligated to pay any certain amount in dividends. A company in very bad financial health might decide to pay out 90 percent of all profits in dividends, whereas a company with excellent prospects may decide to pay out only 10 percent of its profits in dividends, choosing to reinvest the balance in expansion. In these cases, the current yield would then give an inaccurate picture of the company. The current yield is still an excellent tool with which to measure a company’s financial success and potential. The investor must use the current yield within the context of all its background information for maximum results.

Current and Debt Ratios

The current ratio and the debt ratio differ from the previous measurements in that their focus is more on the company’s constitution rather than its health. This means that the current and debt ratios measure the internal infrastructure of the company, including its level of leverage and its solvency potential, rather than its external dealings.

Think of it this way. Say you make $100,000 a year, and your brother makes $50,000 a year. However, you’ve got substantially more debt on credit cards than he does (probably because you didn’t read Lesson 3, “How Much Do You Have to Invest?” as well as you should have). He’s carrying about $5,000 in debt, or about 10 percent, while you’ve racked up about $50,000, or about 50 percent. It doesn’t take a genius to figure out that I’m going to be a lot more comfortable lending your brother money rather than you, for a number of reasons:

1. He’s obviously managing his money better than you are (better management). Thus, I’m convinced he’s going to handle my (loaned) money more responsibly than you will.
2. He’s got a much lower debt percentage to carry than you do. All other things being equal (for both of you, rent = 25 percent of your take-home pay, food = 20 percent of your take-home pay, etc.), you are paying a higher relative loan percentage, even though you are also making more money. And struggling to make debt payments of 50 percent is really struggling.
3. I’ve got a better chance of getting some of my money back from your brother should both of you go out of business or, in this case, declare bankruptcy. Remember again that we’re working on percentages here. Remembering that taxes, fees, etc., are usually based on a percentage rather than the amount, your brother would be liable for only about 10 percent of his total income; whereas you would be liable for half. I’ll take my chances with your brother.

So the formula to determine the current ratio is …

Assets ÷ Liabilities = Current Ratio

This current ratio would indicate the probability that in the case of insolvency (bankruptcy), the investor would get all or some of his or her money back after all debts, bonds, and preferred stock were paid off.

On the flip side, the formula to determine the debt ratio is …

Amount Owed to All Outstanding Bonds

÷ The Company’s Total Capitalization

= Debt Ratio

This debt ratio would indicate the company’s ability to meet the payments of the debt it carries, or how close the company is to bankruptcy. Using this ratio together with the current ratio, an investor can determine how close the company is to bankruptcy and what the chances are of recovering his or her investment, should bankruptcy occur. Although finding out a company’s debt ratio may seem a pessimistic attitude to take, it’s certainly better to know this type of information before making your investment rather than after the fact.

Again, remember that these formulas are useful only to the extent that they are used within their respective contexts. That 10-20 rule for high and low ends still applies as it did with the P/E ratios. However, this figure is going to vary widely, depending on the industry. Some companies, such as those that deal with intellectual property such as computer operating systems like Microsoft Windows, will automatically have fewer tangible assets, creating a low debt ratio (under 20 percent), even though they still might be an excellent investment. Other companies, such as manufacturing firms like GM which produces automobiles, may carry high debt ratios (over 30 percent) owing to the amount of infrastructure required to produce their goods, and yet be teetering on the brink of insolvency. In other words, learning a company’s current and debt ratios isn’t enough: You have to learn what they mean.

Book Value

Having learned how to determine the odds of a company going bankrupt, and the odds of its investors being able to get some or all of their investment back, the next logical question is, “How much will I get back?” Fortunately, the book value will tell you just that, or at least give a reasonable estimate. Similar to the way book values are used in the world of buying and selling secondhand cars, a stock’s book value attempts to determine the worth of a company. Once the book value is known, analysts can subtract the company’s liabilities and divide the remainder by the total number of shareholders to determine how much each investor would receive in the case of the company going out of business.

I am not going to give you the formula for determining the book value, because it is one of those statistics that requires spreadsheets, algebraic calculations, and a Ph.D. in mathematics. Suffice it to say that, like any of the preceding measurements, the book value should be used in context with book values of other stocks within the same industry, as well as the same stock’s own previous performance.

In addition, the book value has another use. Investors routinely compare the book value with the current market price of the stock to determine how far away from its actual value the stock is trading. As a very general guideline, stocks typically trade at one to two times their book value. Higher book values are certainly more desirable. However, I can’t stress enough that, by themselves, these measurements may not necessarily accurately depict the company. You’re going to have to do your homework. The more you learn, the better your investment decisions will be.

Credit Ratings

In the current and debt ratio example, we discussed how much debt you and your brother were carrying and how effectively you were each handling it. As individuals, much of this information about you would be available by means of a credit report to anyone who was entitled to see it. With the information on a credit report, entities like mortgage banks and car lease companies can determine whether or not you or your brother would meet their specific minimal criteria.

Wouldn’t it be a great world if someone would step in and figure out that kind of stuff for you in the stock market? Luckily for you, a number of companies do exactly that. Stocks, like people, get assigned a credit rating, and that credit rating can be used to determine any number of things, including whether or not you choose to purchase that stock as an investment. Such companies as Moody’s and Standard and Poor assign these credit ratings, which are available in most newspapers and on the Internet. The credit ratings for stock are a little more detailed since they measure substantially more, but most break down into nine categories using combinations of As, Bs, and Cs as demonstrated in the following table.

There’s no D, DD, or DDD since you can’t more its bankrupt. Once a company reaches the “D” stage by going bankrupt, its rating gets dropped as you can’t give a rating to a company that’s out of business.

Frankly, few of us enjoy math, but as you can see, through its use you can uncover a substantial amount of incredibly valuable information. As finance, investment, and money are all measured numerically, numbers will provide the best overall picture of a stock’s performance. In addition, the number of formulas you need to extract the most representative view are neither complicated nor many in number. For these reasons, the math part of your stock research should never be minimized or avoided. The time and effort you invest in your research will directly pay off in the potential for your cash investment to flourish.