by Andy Tanner
In the case of the Smith brothers, investors are paying $2.50 per share to get 25¢ of earnings. That means that to get $1 of earnings they are paying $10.
In the case of the Jones brothers, investors are paying $2.00 per share to get 20¢ of earnings. That means to get $1 of earnings; investors in both companies are paying $10.
With an understanding of P/E ratios, you have a huge insight into how much to bid to own shares of the lemonade stand. You know there are opportunities in the neighborhood to get a dollar of earnings for about $10. You know that if you pay more than $10 dollars for $1 of earnings for a business in this neighborhood, you will have to find what factors, if any, justify the price.
Now when we look at Tanner Brothers at $3 per share it makes more sense.
By looking at the other businesses and seeing what investors are willing to pay for one dollar of earnings, the Tanner Brothers can get a sense of what their business is worth. For Tanner Brothers, the price is $3, and the earning per each share is 30¢. All three businesses have P/E ratios of 10.
You will find that when it comes to earnings, a lower P/E ratio means more bang for the buck. In the real world, though, do people really pay for high P/E ratios? If they feel the company has potential, then they absolutely pay for a high P/E ratio.
Price/Earnings and Growth (PEG)
During the dot-com boom you could find people willing to buy stocks with a P/E ratio of 200 or more—meaning they were paying $200 for $1 of earnings. There were actual cases of P/Es that were undefined because the company had not yet made any earnings. Were these investors nuts? Why would investors do this? The answer is future growth.
There was a day, in the early stages of every company, when the company had no earnings. In the 1990s many investors got so caught up in the new startup company frenzy of the dot-com boom, they did not pay much attention to earnings. They saw value in growth, and they were willing to pay for it. We can learn many lessons from the greed of the dot-com bubble.
In the diagram below it is not hard to see that in the context of earnings, company ABC is bringing more value to its investors today.
But the stock market is a forward-thinking place. Investors are buying for tomorrow, not for today. If you look at the same two companies in the context of growth, you might have a change of heart as to which one you want to own.
Company ABC is generating earnings today. Company XYZ is losing money today. The inexperienced investor is only looking at the snapshot. We want to look at the trend to determine where future earnings are headed.
Company XYZ’s trend tells me something about value. If I buy a stock, I’m paying for earnings because that is part of value. But what about growth? Is a company that is growing more valuable than a company that’s not? How can we measure growth as a part of value?
The price I pay for the stock is one factor. The earnings I receive for my investment is another factor.
Now let’s look at the growth of the company as a third factor. Let’s go back to the three small businesses in the Tanner neighborhood and see how they are growing.
When we looked at the price investors paid for earnings, we saw that each business was giving investors the same value for the earnings. But growth is a different story. When investors buy shares of Tanner Brothers, they are getting a company that is growing at 20 percent. Moreover, analysts are projecting that it will have similar growth next year. If it earns even more next year, investors will be getting even more bang for their buck, and it is likely that the share price will rise.
You can see why investors would be willing to pay for earnings, and also why they would be willing to pay for growth.
PEG ratio gives us information on three variables: the price of the shares, the earnings of the company, and the growth of the company earnings.
Tanner Brothers has a very low PEG ratio. That tells you as an investor that for the price you are paying, you are going to get more value for your buck.
It’s always important to keep the big picture in mind.
In our discussion on sovereign fundamentals we found that using ratios helped us understand the relationship between two numbers. I’m terrible at math, and I really don’t care to do a lot of calculations. I don’t like fractions and numerators and denominators and all that stuff. I just want to learn to tell the story of the financial statement.
We learned in our discussions on sovereign fundamentals that ratios often include the relationship between GDP and some other number in the financial statement. When it comes to corporate fundamental analysis, we often encounter ratios that describe the relationship of price to some other number. Why? Because price is merely what we pay, and we want to figure out what we are getting for our money. When we compare the price to different parts of the financial statement, we can begin to understand what we are actually paying for. That’s the big picture we’re looking for.
Ratios simply tell us how much money we are spending in relation to how the company is performing in different areas of its financial statement.
As a shareholder you want to know how much you are paying for a share of the earnings. How much are you paying for a share of the sales? And how much are you paying for a share of the equity? The price by itself really does not mean much. Only when we compare it to the financial statements does it help us understand what kind of value we receive.
How Do You Apply This in the Real World?
Some time ago, Apple Computer hit a new high for the year. Robert called me that day and we talked about Apple’s meteoric rise. At first it seemed unlikely that the price would go any higher. The stock chart looked like the price was almost going straight up. Many people were wondering if this was sustainable. Perhaps it was time to change positions and short the stock to make money on a downfall. (We will learn in a later chapter how to short a stock as a way to make money when a stock runs out of gas and goes down).
Remember that price really does not mean much when viewed by itself—even at $400 or $500 a share. In fact, Apple’s earnings were actually keeping pace with its stock price. Apple had a P/E ratio around 13 that day. That meant investors were spending about $13 in price for every one dollar of earnings. The average P/E for the average stock in the NASDAQ was around $17. That means the average stock in the NASDAQ was costing investors around $17 in price for every one dollar of earnings. From an earnings standpoint, Apple was still cheap, even though it was at $500 per share!
Apple continued its rise—to $700 a share! Only when the fundamentals began to show a slowdown in their rate of growth did the stock begin to fall. The people who paid attention to price alone should have looked at the fundamentals. Later on we will also see how the second pillar, technical analysis, is also a factor to consider.
Market Capitalization
What if you decided to buy all the shares in a company such as Oracle or Exxon Mobil? As you can imagine, these companies have issued millions and millions of shares of stock. And it would cost you billions of dollars to buy every single share. While coming up with that kind of cash might be very difficult, figuring out the total price tag is very easy. This is known as market capitalization, or market cap for short. Simply do a little research to discover how many shares are currently issued, and then find the current price of those shares.
If we go back to our smaller lemonade-stand example, a total buyout might be within your budget:
You can see that market capitalization is a number we can easily calculate to determine the value of an entire company. For the Tanner Brothers lemonade business, we multiply the share price of $3 by the number of outstanding shares (100) to get the market capitalization of $300.
Market Capitalization = (Share Price) x (Number of Outstanding Shares)
The market cap is the price you’d have to pay to buy every share and own an entire company.
At the other end of the spectrum, Apple has a very high market capitalization—in the hundreds of billions, making it among the largest companies in America
. With a wide variety of companies—all with different amounts of market capitalization—investors categorize companies according to their market caps:
But is one type of market capitalization better than another?
The thinking here is that the large cap companies are well-established, their balance sheets are big, and there is, at least in theory, less risk. The smaller companies have more room for growth; potentially they could go big-time. But with small-caps there’s more risk; they may never make it. A small-cap company could blow up, but it could also blow out. It could do well or it could do poorly. To try to work out a most likely scenario, you need to know something about its earnings, the stock price, the number of shares, its market capitalization, and if it’s showing signs of growth.
Some Valuable Investing Vocabulary
Part of what we’re trying to do here is to learn the vocabulary that helps us to translate information into meaning. If you don’t have this vocabulary when you watch the financial news, read a periodical, talk with your advisors, or go to buy a stock, then the information may have less meaning for you. Each asset class—business, real estate, stocks, commodities—has its own vocabulary.
This chapter is adding several new words to your investing vocabulary: PE, PEG, market capitalization, etc. Understanding these words makes you a more intelligent investor and helps you progress along the Education Continuum™.
Now let’s do a wealth-building activity to put some meaning to these numbers and vocabulary.
Education Activity
In Chapter One I challenged you to do more than just read this book. I challenged you to discuss what you are reading with others and to find activities to enhance your learning. You can practice everything we’ve discussed so far by comparing several different stocks—their values, their PEs, their PEGs. You can do this if you have some stocks of your own or you can do it by choosing some stocks at random. If you don’t have a current software service you prefer, you can easily use a free service such as Yahoo! Finance or Google Finance to get this information.
This can be a lot like a game or a treasure hunt. Try to find the information for each valuation in the table. Also try to visualize what part of the financial statement the valuation is related to. When you focus on an individual stock, look for the key statistics (that’s an actual category on some websites such as Yahoo! Finance) to view all the essential information.
First we have market cap, or market capitalization. We now know this is the total dollar value of the company. Choose a company and see if you can find information on its market cap.
Enterprise value is similar to the market cap, but it includes the liabilities. So it tells us that if we actually owned the stock, we’d have some cash and some debt to deal with.
The P/E is the price/earnings ratio. The trailing P/E is this ratio as of yesterday. And ttm stands for trailing twelve months, meaning (as you’ve probably guessed) that the numbers are measuring at the earnings over the last 12 months and are the ratio between those earnings and the intraday price (average price over the course of the current day).
With the forward P/E, you can project what the fiscal year ahead might look like. But that’s not necessarily a reason to hold off buying the stock, because the price could be more expensive then.
Look at the PEG ratio expected for the next five years. A PEG of 0.5 or better means that the company is growing really well. A PEG of two or more means it is not growing as well.
What’s our next statistic? Price/sales. This is simply the share price divided by the sales revenue. It’s the relationship between the cost of the share and the income generated by sales. This is not earnings, because we have not yet subtracted the expenses. It doesn’t represent the company’s profit or loss—just the sales. The price/sales ratio tells you how much every dollar you have paid for the stock is generating in sales.
How about price/book? This ratio gives us the accounting value of the equity. This is what you are paying for your assets in the most recent quarter (MRQ).
We don’t need to be too concerned, right now, with the next two ratios…but here are the definitions. Enterprise value/revenue simply gives a measure of the value of the company in relation to its revenues. And enterprise value/EBITDA is a measure of the value of the company in relation to its earnings before interest, tax, depreciation, and amortization (EBITDA).
You can look at any stock in this way, learning a bit about value, fundamental analysis, and the strength of an entity.
Next, see how your stocks compare to each other.
Stock comparison
Let’s compare Proctor & Gamble (P&G) and Apple. Both are large-cap companies with market capitalization of more than $10 billion. But there’s a big difference in the price of Apple shares, when it was trading at around $600, and the price of P&G, trading around $60
Even at 10 times the price, Apple gives the investor more earnings for the price. Based on this analysis, it also looks like Apple gives more value in terms of growth than P&G. So why would anyone choose P&G?
Traditionally P&G has had a policy of paying a dividend of about 3.7 percent. Apple has only recently begun to pay dividends, but has not paid them in the past.
So while a person might want to know which stock is better than the other, the answer is that it depends on that individual’s personal goals. If your goal is for income, you might adopt a policy of buying stocks that pay a high dividend. Therefore, you might be willing to pay a little more in P/E if you can actually get a return on your money in the form of a dividend.
Don’t forget about that dreaded obsolescence risk. In this example, P&G offers less of it, meaning its products are less likely to become outdated with new advancements in technology.
Other investors are more interested in growth. In that case, a stock such as Apple may be more appealing. Apple reinvests a large amount of its earnings into growing the company and developing new technology to fight obsolescence risk. Because of that, it might have less money to pay in dividends. But the share price is likely to go higher—if the company does grow.
As we have seen, Apple and P&G are two very different types of stocks for investors. Depending upon your own financial goals, you could be interested in one or the other of these stocks to help you achieve what you are looking for—income or growth—to improve your personal financial statement.
Now let’s look at Apple and compare it to other stocks in the same technology sector.
Apple’s P/E came in lower than the average P/E for the technology sector. So while some people might feel uncomfortable spending hundreds of dollars per share, they can take comfort in knowing that they are still getting more bang for their buck than with the average tech stock.
Personal Fundamental Analysis
At the beginning of this chapter, I said that fundamental analysis could give us answers about the financial strength of any entity.
Now that we have explored fundamental analysis of sovereign nations and corporations, let’s turn our attention inward. As we analyze our own personal financial statements using these same tools and numbers, we can begin to see our true financial health. Knowing this information can help us address our own policies in achieving our financial goals.
This is also a good point to remind ourselves about the relationship between financial statements and policy.
While we cannot change government policy or corporate policy all by ourselves, we can change our personal policies. This is good news. You control your own destiny. No matter how poorly the world economy becomes, if your own personal financial statement is healthy, you will be safe. When it comes to your own personal financial statement, you can be in total control.
Lessons from Real Estate
To begin our discussion of personal fundamental analysis, let’s start with an investing analogy related to real estate. As investors, there are three ways we can use real estate to accomplish our goals:
•Capital gain: buy a new house and then flip it to
earn a capital gain on our money
•Cash flow: buy a new house and rent it to earn income for ongoing cash flow
•Hedge: buy insurance on the property to protect it
All three of these are valid actions. And we can also achieve all of them in any asset class. One is not better than another, because it all depends on our own individual investing goals. It’s important that we know about these different options so we can make smart decisions.
As a reminder, let’s see how these different investment approaches appear on our financial statements. When you buy a house in hopes that the value of it will grow to achieve a capital gain, you will enter the value of that house in your asset column. At that point, the value of that investment can grow or decrease in value, depending on the market. This fluctuation will affect your net worth. Knowing this, you can ask yourself this important question: “What are my investing goals? Is one of them to increase my net worth? If so, what investments should I buy to accomplish this?” Stock investors have a similar option available to them. If they want to increase their net worth with stocks, they can buy shares and hold them in their portfolio, hoping they increase in value. Many people are already doing this through retirement plans such as 401(k)s, IRAs, and mutual funds.
However, if you decide to rent that house to someone else you will generate cash flow from your asset. Cash flow is valuable to you because it’s how you are able to feed your family and pay your bills. Simply having an asset that increases your net worth does nothing to improve your cash flow situation. That’s why Robert encourages people around the world to think differently and seek to buy assets that give them cash flow. When we have assets that generate cash flow for us, it can help us now and through retirement. Remember: Net worth doesn’t help you retire; cash flow does. That’s an important distinction to make. If you are renting your houses, that is cash flow that goes into your income statement. It’s an important addition to your income statement that can transform your life.
