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, you’ll 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 12month’s earnings) to recent or
projected earnings growth rates. Now valuation is even more important,
but in many cases P/E isn’t meaningful because recent earnings, the
“E” in P/E, are either depressed or nonexistent.
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 Money’s Key Ratios group of reports. Find them from MSN
Money’s 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 stock’s
acceptable P/E depends on the underlying firm’s 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 isn’t useful if a company’s earnings
are abnormally depressed. However, since sales are more stable than
earnings, you can use the price/sales (P/S) ratio to derive a
“normalized” 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 firm’s profit margins were at
historical (normal) levels.
If you do the
math, you’ll find that the P/E ratio is equal to the P/S ratio divided
by the firm’s net profit margin (net income divided by sales). You can
find the current P/S on MSN’s Key Ratios’ Price
Ratios report.
Instead of
using current net profit margins, it’s best to estimate a firm’s
normalized net profit margins using history as a guide. MSN’ Key
Ratios’ 10
Year Summary lists 10 year’s 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 firm’s outlook is such that it’s
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 HarleyDavidson or newspaper publisher
KnightRidder. In these cases, a 2.5 P/S converts to a 25 normalized
P/E (10 x 2.5).

Discount
retailers such as WalMart 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,
Microsoft’s 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.
Profitability
Often overlooked by individual investors, profitability is different
than profit margin. Profitability ratios compare a firm’s 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 highdebt companies look more profitable than
lowdebt firms with the same earnings and assets.
Both are
listed in MSN Money’s Key Ratios’ 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.
Debt
The steady stream of high profile bankruptcies underscores the need to
examine a company’s 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 MSN’s Key Ratios’ Financial
Condition report.
The D/E ratio
compares a firm’s debt to its book value. A zero D/E is best since it
signals no debt. Generally, firm’s with D/E ratios below 0.5 are
considered low debt, but lower is better. MSN’s D/E ratio counts only
longterm debt. That’s usually good enough, but some firms have
replaced longterm debt with continually refinanced shortterm debt. You
can check a firm’s total (long and shortterm) D/E on Yahoo’s (quote.yahoo.com)
Profile report.
There’s
nothing wrong with highdebt, in terms of solvency at least, if the firm
generates enough cash to comfortably service its debt. The interest
coverage ratio compares a company’s 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 WalMart and recently bankrupt WorldCom reported identical 0.5
D/E ratios on their latest reports. However WorldCom’s interest
coverage ratio of 2 signaled danger compared to WalMart’s healthy 10
ratio.
Obviously
simply passing these guidelines doesn’t insure success. You still have
to do your due diligence and thoroughly research each candidate’s
business prospects.
published 8/25/02 