Stock Analysis 101: Lesson 1

Fundamental Analysis of Stocks

Metric #1: Price to Earnings ratio

A stock’s P/E ratio is derived by taking the stock’s current market share price and dividing it by its per-share earnings.

Ex:

If company A has common shares that closed at $25.55 on 9/10/14 and reported earning $1.25 per common share during its last annual report, then the P/E ratio for this stock would be

$25.55/$1.25 = 20.44.  A stock's P/E ratio is dynamic because the price of a stock changes daily, but a company's earnings for the previous year is unchanged.  It earned whatever it earned after four quarters (12 months) and there is no changing the reported quarterly earnings.

The PE ratio is also known as a stock’s earnings multiple because you can take the ratio, multiply it by the company’s earnings per share and get the price of the stock: 20.44 x 1.25 = 25.55.

Valuing a Stock using the PE ratio:

Generally speaking, stocks with PE ratios that are between 1-10 are considered “speculative.”  In contrast, stocks whose PE ratios are between 10-22 are considered “value” plays.  Finally, stocks with PE ratios between 22 and beyond are considered “high multiple,” expensive stocks with the exception of:

1. A stock that is growing its earnings at a greater than 15% rate a year.
2. Tech stocks or other higher traditional multiple stocks such as REIT (Real Estate Investment Trusts).  There is an expected range in terms of PE ratios for a given industry.

High multiple/rapidly expanding growth stocks e.g., Facebook (FB) with a PE ratio of 84, will command a higher share price.  At the same time, if they “miss” on their earnings on a subsequent quarter or two or more consecutive quarters, the shares of these stocks will plummet much more so (with higher volatility) than a stock with a more modest PE ratio, e.g., Apple (AAPL) with a PE ratio of 16.30.  Why?

Limitations to Using the PE ratio to compare companies in the same industry

In the case of Facebook, an investor is paying up for the growth in Facebook, whereas Apple is after many years of existence no longer in its growth phase as a company.  Both Facebook and Apple are in the tech industry.  Yet, comparing FB stock to AAPL stock comes with the necessary understanding that these two companies are in different places in their “life cycles” and the PE ratio will not suffice to compare the two.

Benefits to Using the PE ratio to compare companies in the same industry 

Which stock is better, McDonald’s or Burger King’s?  Both are in the fast food industry and have been around for some time.  MCD’s PE ratio is 16.83.  BKW’s PE ratio is 41.63.  From a valuation standpoint, MCD is in the “value” range whereas BKW is in the “expensive” range.  It is good to know this.  However, an investor must still do their due diligence and figure out if the higher multiple in BKW is warranted or if it is not, i.e., if the stock is accurately priced at $31.39 a share as of 9/10.  MCD’s share price as of 9/10 was $93.0.

A person simply looking at the price of the stock would think that BKW is cheaper, when in fact the price of the stock is not telling at all whatsoever, rather, the PE ratio clearly shows that MCD is the cheaper stock at $93.0!!  Let’s bring on another fast food restaurant player: Jack in the Box or JACK.  As of 9/10/14, the price of the stock was $62.88.  Cheaper than McDonald’s?  Look at the PE ratio, not the price!  JACK’s PE ratio is 26.71.  So, no!  MCD at $93 with a PE ratio of 16.83 presents a better value for an investor.

Your homework: Determine which stock is the least expensive using PE ratios:

NKE or SKX

HD or LOW

F or GM

DE or CAT

Extension:  What is the 5-year growth rate in earnings per share for the following stocks: (Use the 10-year Summary link at MSN Money).  Hint: 

Growth rate = final value - initial value / initial value, then X 100.

General Electric (GE)

Target (TGT)

Based on the earnings growth rate for the past five years on the above two stocks, would you buy GE or TGT today?  What Unknown would make you hesitate buying any stock solely on the basis of a 5-year growth rate?

Until the Next Lesson!   Want to check your answers?  Email me.  Questions?  Post a comment.