Harry Domash's Winning Investing


New Rules for Valuing Stocks

The market is performing better and many pundits are advising us to start dipping our toes back into the water. They may be right, but when you begin evaluating prospects, youíll find that some of the old rules no longer apply.

For instance, in the past, growth investors typically valued stocks by comparing their P/E ratios (trading price divided by 12-monthís earnings) to recent or projected earnings growth rates. Now valuation is even more important, but in many cases P/E isnít meaningful because recent earnings, the ďEĒ in P/E, are either depressed or non-existent.

Here is a way to get around the P/E dilemma, along with two more ideas to help you evaluate stocks in this environment. You can find all of the needed data on MSN Moneyís Key Ratios group of reports. Find them from MSN Moneyís homepage (moneycentral.msn.com/investor) by getting a stock price quote, clicking on Financial Results, and finally selecting Key Ratios

P/E Stand In  
P/E is one of several ratios available to value a stock by comparing its current trading price to a fundamental factor such as cash flow or book value. However P/E is the most widely used valuation ratio, especially among growth investors.

A stockís acceptable P/E depends on the underlying firmís earnings growth prospects. There is no universal standard, but most experts would probably agree that 25 is in the ballpark for a company expected to grow earnings around 20 percent to 25 percent annually. Faster growers would likely merit higher valuations. Firms with little or no growth prospects typically trade at a 10 or so P/E.

As I mentioned earlier, a P/E ratio isnít useful if a companyís earnings are abnormally depressed. However, since sales are more stable than earnings, you can use the price/sales (P/S) ratio to derive a ďnormalizedĒ P/E. The P/S ratio is similar to P/E except it compares the stock price to sales instead of earnings. Normalized in this sense means the P/E assuming that the firmís profit margins were at historical (normal) levels.

If you do the math, youíll find that the P/E ratio is equal to the P/S ratio divided by the firmís net profit margin (net income divided by sales). You can find the current P/S on MSNís Key Ratiosí Price Ratios report.

Instead of using current net profit margins, itís best to estimate a firmís normalized net profit margins using history as a guide. MSNí Key Ratiosí 10 Year Summary lists 10 yearís history. Pay most attention to the 1998 and earlier figures since many firms reported record high margins in 2000 and below normal or negative margins since then. Of course, this analysis doesn't work if the firmís outlook is such that itís unlikely to return to historical profit margins.

The way the formula works, you end up multiplying the P/S ratio by a factor (multiplier) to find the normalized P/E. Here are some examples: 

  • The multiplier is 10 for firms with 10 percent net profit margins, typical of many manufacturing and service companies such as motorcycle maker Harley-Davidson or newspaper publisher Knight-Ridder. In these cases, a 2.5 P/S converts to a 25 normalized P/E (10 x 2.5).

  • Discount retailers such as Wal-Mart and Costco operate on 3 percent profit margins. For these low margin cases, the multiplier is a much higher 37, and a P/S of only 0.7 corresponds to a 25 P/E.

  • Software firms and some others generate very high margins. For instance, Microsoftís net profits normally run around 25 percent, resulting in P/S multiplier of only 4. In this instance, a 6.2 P/S corresponds to a 25 P/E.

Often overlooked by individual investors, profitability is different than profit margin. Profitability ratios compare a firmís net income to its book value (shareholders equity), to its total assets, or to a similar measure. Profitability is important because high profitability firms can grow by reinvesting earnings, while lower profitability firms must continuously borrow or issue more shares to finance growth.

Return on Equity (ROE) and Return on Assets (ROA) are popular profitability measures. ROE is the most widely used, but unlike ROA, has the disadvantage of making high-debt companies look more profitable than low-debt firms with the same earnings and assets.

Both are listed in MSN Moneyís Key Ratiosí 10 Year Summary. Look for a minimum 15 percent ROE or a 5 percent minimum ROA, and higher is better for both. As with net profit margins, for many firms the 1999 and 2000 profitability ratios will be abnormally high, and the more recent figures abnormally low.

The steady stream of high profile bankruptcies underscores the need to examine a companyís debt levels, and its ability to service its debt. The debt to equity (D/E) and interest coverage ratios are key gauges in that regard, and both are shown on MSNís Key Ratiosí Financial Condition report.

The D/E ratio compares a firmís debt to its book value. A zero D/E is best since it signals no debt. Generally, firmís with D/E ratios below 0.5 are considered low debt, but lower is better. MSNís D/E ratio counts only long-term debt. Thatís usually good enough, but some firms have replaced long-term debt with continually refinanced short-term debt. You can check a firmís total (long- and short-term) D/E on Yahooís (quote.yahoo.com) Profile report. 

Thereís nothing wrong with high-debt, in terms of solvency at least, if the firm generates enough cash to comfortably service its debt. The interest coverage ratio compares a companyís earnings before interest and taxes (EBIT) to its annual interest expense. Financial analysts usually specify 4 as a minimum acceptable interest coverage ratio, but higher is better.

To illustrate why the D/E and interest coverage ratios must be used together, consider that both Wal-Mart and recently bankrupt WorldCom reported identical 0.5 D/E ratios on their latest reports. However WorldComís interest coverage ratio of 2 signaled danger compared to Wal-Martís healthy 10 ratio.

Obviously simply passing these guidelines doesnít insure success. You still have to do your due diligence and thoroughly research each candidateís business prospects. 
published 8/25/02


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