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
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
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
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.
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
using current net profit margins, itís best to estimate a firmís
normalized net profit margins using history as a guide. MSNí Key
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:
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).
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.
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.
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.
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
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)
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
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
simply passing these guidelines doesnít insure success. You still have
to do your due diligence and thoroughly research each candidateís