Doc Maher continues his series on fundamental analysis with a lesson in how to use these numbers.
"Stock price reflects the expectation of a company's future earnings discounted back to today."
I introduced this idea in my first post of this series. This time I'll start to delve into what kinds of things to look at when evaluating a company.
If earnings are at the heart of the stock value, then how do we measure this? Each quarter public companies are required to publish their financials and file them with the SEC in what is called a 10Q. At the end of the year they also file a summary of the year in a 10K. There are three financial statements that are filed: Balance Sheet, Cash Flow, and Income Statement. All of these have valuable information on them however most people don't know how to read or interpret it.
One of the important numbers we need is called Net Earnings which may be found on a preliminary 10Q, on the Income Statement. You don't have to look too hard because earnings are widely published and can be found in a number of places. Net earnings are interesting, however Earnings Per Share (EPS) is more interesting. This is the total amount earned divided by the number of outstanding shares.
Since you are buying a share of the company to get a share of the earnings, you want to know how much you are paying for one of these shares. This is called the Price to Earnings Ratio (P/E) ratio. You take the price of the stock and divide it by the EPS. The P/E ratio is always quoted using annualized earnings. That is, even though the earnings are for the most recent quarter, this number is multiplied by four to annualize the number. This is as though the year would have the same earnings every quarter.
What should the P/E ratio be? Well, how much are you willing to spend to obtain a certain amount of earnings? If we wanted earnings of 10% of the stock price, the P/E would be 10. Is that a good number? Well as we always said in business school "it depends". Let's look at what the average P/E ratio is for the S&P 500. In 2007 the average P/E ratio for the S&P 500 was 27.73. That means that for every $1 in earnings the average stock price was $27.73. So compared to that a P/E of 10 looks pretty good.
Of course there is more to it. We can find this type of information on TradeKing.com under Quotes + Research > Quotes + News + Research > Summary (scroll down towards the bottom). Below is a picture of data for Caterpillar (CAT).
Click here for a larger image.
I have highlighted the line item for Price / Earnings. Caterpillar's P/E is 10.94. There are also P/E ratios listed for Industry Average, Sector Average, and S&P 500 for comparison. We'll discuss some of the other "Key Measures" in future posts.
If you look up GOOG, the P/E ratio is 29.53. Is CAT a better buy than GOOG? Is GOOG over-priced? Amazon.com has a P/E of 59.12. Why do these three stocks have different P/E ratios? Why doesn't the market establish what the P/E ratio should be and adjust all the stock prices accordingly?
The short answer is that earnings change. The stock price is determined by the "expectation of future earnings." All we are looking at is a snapshot sometime in the past. Another problem is in the way companies report earnings and the way in which the market interprets them. If a company has a "one time charge against earnings" for some extraordinary reason, this will lower the earnings per share. However the market may focus more on what the earnings would have been if the "one time charge" was ignored.
So what do we do? How do we compare these numbers? Well analysts have come up with another ratio that tries to account for future growth. This is called PEG. It stands for Price / Earnings to Growth ratio. It is calculated by taking the P/E ratio and dividing it by the annual EPS growth rate. This is a widely used measure of valuation. The theory is that a PEG of one means that the stock is fairly valued. If it is greater than one, the stock may be over-priced. If it is less than one, the stock may be undervalued.
So let's go back to CAT, GOOG and Amazon, but this time we will use the PEG ratio. I'm going to go to Yahoo Finance and look under "Key Statistics" where I'll find the PEG calculated for me. See: "PEG Ratio (5 yr expected)".
For CAT it looks like this:
Here is a comparison of all three stocks:
CAT: PEG = 0.92 P/E = 10.94
GOOG: PEG = 0.79 P/E = 29.53
AMZN: PEG = 1.95 P/E = 59.12
By this measure GOOG is now the cheapest stock and Amazon is still the most expensive. The problem is that this uses a projection of future growth and of course we don't know how accurate that is or what might change that projection. It is also a time horizon of five year expectations. The time horizon may not be what we need to conduct our analysis. PEG ratios may vary depending on which site you use because the ratio may be calculated differently. The number may reflect different expected growth estimates or different time periods. The PEG ratio may also be found on TradeKing.com under Quotes + Research > Quotes + News + Research > Earnings. See below.
Click here for a larger image.
Here the PEG for CAT is 1.2 which is different from Yahoo's data of 0.9. This most likely reflects a different time horizon and possibly a different growth projection.
"Stock price reflects the expectation of a company's future earnings..."
P/E ratios and PEG will vary by type of business or industry as well. PEG ratio is more often analyzed when evaluating high growth stocks than for low growth stocks. High growth industries will tend to have higher P/E ratios because the expectation is that they will grow into the higher stock price, even if they are not generating that much in earnings yet.
"...future earnings discounted back to today."
Risk is also a factor. Industries that are perceived to have higher risk may have their stock prices deflated. The higher the risk the bigger the discount.
So how can AMZN hold its price with a P/E of 59 and a PEG of 1.95? Well remember that it's "expectations" that count. People hold the expectations, and people's actions are influenced by many things. It may also take time for things to take hold. Not all that long ago GOOG had a PE of 100. Crazy? Yes, probably, but now its P/E is down to 29 and the PEG is 0.79. Will the same happen for Amazon? It's hard to say. We'll have to wait and see.
Many things impact the "expectation of future earnings" and we have only scratched the surface. We will be digging further into this subject in upcoming writings.
"Income Trader"
Doc's previous posts: Why is Fundamental Analysis Important and Puts on Google
Click here for a list of previous TradeKing All-Star blogs.
Nicole Wachs contributed to this post.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
