The 1-2-3s of Ratios for Investors
09/08/2010 4:48 pm EST
When it comes to stocks, many retail investors develop an irrational case of ratio-phobia, says GlobeInvestor.com’s reporter and columnist John Heinzl.
Ratios are an indispensable part of everyday life. For instance, when you make a martini (four parts gin, one part vermouth) or place a sports bet (the Oilers are a 100:1 shot to win the Stanley Cup), you’re using ratios.When it comes to stocks, however, many retail investors develop a case of ratio-phobia. All those numbers seem so complicated!
You need a PhD in finance to understand what they mean!
No, you don’t. All you need is this edition of Investor Clinic. We’ll look at a few of the most basic investing ratios, starting with the price-to-earnings ratio.
THE P/E RATIO
Take the current stock price. Now, divide it by the company’s annual per share earnings. Voilà: That’s your price-to-earnings ratio. For example, if a stock is trading at $10, and the company made $1 in annual profit, the P/E is 10. If the stock trades at $50 and profit is $2, the P/E is 25. In other words, the P/E shows how much investors are willing to pay for $1 in earnings.
Where P/Es get a bit tricky is the E part of the equation. In some cases, the E refers to earnings over the previous 12 months. In others, it refers to projected earnings over the next 12 months, or the next fiscal year. To confuse things further, the E may or may not include one-time items such as restructuring charges.Let’s look at a real-life example. Telus Corp. posted profit of $3.12 over the previous four quarters, and its stock closed yesterday at $44.75. Its trailing P/E multiple is therefore $44.75/$3.12 or 14.3. Based on Telus’s estimated profit of $3.50 in fiscal 2011, the stock is trading at a forward P/E multiple of 12.8
Typically, the stock market will accord a higher P/E to a company whose earnings are growing faster, and a lower P/E to one whose earnings are growing more slowly.
The danger with high P/E stocks is that the lofty expectations built into the share price may not materialize, sending the stock south in a hurry. The danger with low P/E stocks is that the company may be facing competitive or financial challenges, which is why the market gives them a low multiple.
THE PEG RATIO
The PEG ratio takes the P/E one step further by factoring in the company’s earnings growth rate. To calculate the PEG, divide the P/E ratio by the company’s projected growth rate over the next one to five years.The PEG ratio is just a rule of thumb. It was popularized by legendary US fund manager Peter Lynch, who said in his book One Up on
Wall Street that “the P/E ratio of any company that's fairly priced will equal its growth rate.” In other words, investors should look for companies with a PEG of one or less.
As an example, a company with a P/E of 20 and a projected earnings growth rate of 25 percent over the next several years would have a PEG of 20/25, or 0.8. The PEG ratio, of course, is only as good as the earnings projection. Analysts are notoriously bad at predicting where earnings are heading in one year, let alone three or five years.
THE EARNINGS YIELD
The earnings yield is the P/E ratio flipped on its head. It’s the company’s annual earnings per share, divided by the share price. Example: If a stock is trading at $20 and the company makes $1.50 a share in annual profit, the earnings yield is $1.50/$20 or 7.5 percent. In other words, the earnings yield shows how much profit a company generates relative to the price investors are willing to pay for its shares.Some investors—notably Warren Buffett—like to compare a stock’s earnings yield to the yield on government bonds.
The earnings yield should be higher—usually substantially higher—to compensate for the additional risk of owning equities. For example, the earnings yield on Bank of Montreal is currently about 8.1 percent, based on estimated fiscal 2010 earnings. That compares with a yield of less than three percent on Government of Canada bonds.
It’s important to remember that the earnings yield doesn’t measure the investor’s actual return. Companies may reinvest all of their profits in the business or pay out a portion to shareholders, so the earnings yield will usually differ from the dividend yield, which is our next ratio.
THE DIVIDEND YIELD
This is the annual dividend paid by a company, divided by the current stock price. Example: Say you bought a stock for $25 that pays $1 in annual dividends. Your dividend yield would be $1/$25 or four percent.Simple enough. Where people get tripped up is that the dividend yield is always changing.
Say the stock climbs to $30, but the annual dividend remains at $1. The dividend yield would therefore be $1/$30, or 3.33 percent. If the stock price falls to $20, the dividend yield would be $1/$20, or 5 percent. See a pattern here? The dividend yield falls as the share price rises, and vice versa, as long as the dividend itself stays the same.
What if the dividend changes? Just divide the new annual dividend by the current stock price, and that’s your new dividend yield. Typically, the dividend yield quoted in newspapers and on Web sites is what’s known as the indicated yield. It’s based on the projected annual dividend over the next year, which is usually the most recent quarterly dividend multiplied by four.