Welcome to Market Analyze

A ratio is a helpful numerical tool that you can use to find out the relationship between two or more figures found in the 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 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 you find out that the same company had earnings of $75 million in the prior period? Does that change your mind? Two key ratios to be aware of include

• Price-to-earnings ratio (P/E)
  
• 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.

Many brokers have them at their Web sites (such as Charles Schwab at www.schwab.com and E*TRADE at www.etrade.com). Some excellent stock screening tools can also be found at Yahoo! (finance.yahoo.com), Business Week (www.businessweek.com), and Nasdaq (www.nasdaq.com). 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. This is a good starting point for serious investors. 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 — 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 the company more profitable.

More profitability in turn has a beneficial impact on the company’s stock price. The danger with a high P/E is that if the company doesn’t achieve the hopeful results, the stock price could 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. If you come to me and say, “What do you have to offer?” I may 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 ($1 million divided by $2,000 = a P/E of 500) 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 higherthe 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. “Cap” is short for capitalization (the total number of shares of stock outstanding times 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 generally have a P/E that hovers in the 9–14 range. Therefore, if you’re considering an electric utility with a P/E of 45, then something is wrong with that utility.
  
• 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 but 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 .
  
• 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 could 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 it. Can you still make money buying a stock with no earnings? You can, but you aren’t investing; you’re speculating.
  

Listening to a PSA about PSR

The price to sales ratio (PSR) is the 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 (see the section “Market value,” earlier in this chapter, to find out what this term means) 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 you want an alternate way to value a company that doesn’t have earnings.
  
• By analysts who want a true picture of the company’s financial health, because sales are tougher for companies to manipulate than earnings, which are easier to manipulate.
  
• When you’re considering a company offering products (versus services).
  

PSR is more suitable for companies that sell items that are easily counted (such as products). Companies 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.