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Dollars from Sense Chapter IIIB

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Investing - Dollars from Sense

Written by Hugh McManus

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Chapter IIIB The Stock Selection Guide—Part 3  What we’re going to coverIn this section, we’re going to look at part 3 of the stock selection guide.  Section 2 is an evaluation of management and looks at pretax profit expressed as a percent of sales, and the Return on Equity (ROE) or the return on invested capital; it was discussed in Chapter IIIA.  These tools when used together give a great insight into the management of a company.  Section 3 is an evaluation of the PE ratio and the dividend yield.  These tools feed into section 4 of the SSG when it comes to predicting future stock price behavior. Section 3 of the Stock Selection GuideSection 3 of the SSG is a review of the PE ratio.  It is used as an indicator of what might happen in the future.  The PE ratio is determined by dividing a stock price by the earnings per share for one year.  For example, if a company earns two dollars per share and has a stock price of $50, the PE ratio is 25. ($50 ¸ 2 = 25)Since stock prices change constantly, so too does the PE ratio.  A PE ratio at the close of Monday is likely to change on Tuesday.The PE ratio puts companies on an equal footing.  It puts the stock price in terms of earnings.  One informative way to view the PE ratio is that it is the price of earnings!This book has focused on earnings as the driver for stock appreciation.  So when you buy into a company, you’re buying it for its earnings and ability to increase earnings in the future.  You can view the earnings as your money.  However, you have entered into a relationship with the Board of Directors of the corporation that gives them the right to decide the fate of those earnings.  If they elect to pay you a dividend with all or part of those earnings, so be it; they could decide to retain the earnings and use them to grow the company.  Whatever the fate, these earnings per share is your money, even if you cannot control its fate.  When you buy a stock, the PE ratio tells you how much you’re paying to own those earnings.If the PE ratio is 20, you can imagine that the value of $1 of earnings from the company is $20. ($20 ¸ 1 = 20) If the same company traded at $18 dollars the next day, the PE ratio is now 18—you’re being asked to pay $18 to own $1 in earnings.  If you look at the completed SSG in Appendix 2, the PE ratio for Clayton Homes is 8.49—the market says $1 of earnings from Clayton Homes is worth $8.49.  In fact, Clayton Homes generated $1.06 in earnings, so $1.06 in earnings is worth $9 to the market.The PE Ratio and GrowthThe PE ratio says something about the anticipated growth rate of a company.  Let’s say you had two companies in a given industry.  One had a PE ratio of 5 the other had a PE of 50.  Keep in mind the earnings are your money, and the PE ratio is how much you pay for each dollar of earnings.  In one case, you’re offered $50 for a dollar of earnings, the other offer is $5.  But you’re not just buying earnings, but an earnings machine—a company that will keep on pumping out earnings in the future.  When the market bids a stock price up so that it has a high PE ratio, it’s really saying “it’s worth paying a lot for those earnings now, because you’ll likely get even more in the future.”  Pay now, benefit later.  When the market doesn’t bid a stock price up, it’s probably saying “we’re putting more emphasis on earnings today, since we don’t expect dramatic growth in earnings in the future.Let’s harp on this point a little more, by taking it to an extreme.  Company A has a PE ratio of 1—that’s right “one.”  Company B has a PE ratio of 1,000—one thousand.  Let’s say that each has generated $1 in earnings.  With PE of $1, you’re being asked to pay $1 (to buy a share of the company) to get $1 in earnings.  It sounds to me like the chances are slim that the company will generate earnings in the future.  With a PE of 1,000, you’re being asked to pay a thousand bucks to own one dollar in earnings.  The signal here is that you’ll get even more earnings in the future—at least, that’s what the market (the collection of all investors) thinks.So far, we’ve talked about a PE ratio for a single company; however, you can develop a PE ratio for an entire group of companies.  This aggregate PE ratio is calculated by taking the individual PE ratios and averaging them.  The average is often weighted by the size of each component company.  In this way, with enough companies in the average, you can calculate a PE ratio for the entire market!The market overall trades, historically, in a PE range anywhere from 8 to 25.  There appears to be a correlation or relationship between the PE and the rate of anticipated growth in the market.  When the growth rate in earnings is high for the market, the PE for the overall market trends up.  When grow rates stagnate (during a recession, for example), PE ratios may tend down.  This behavior works for companies too.  Companies with a high growth rate in EPS have a high PE and vice versa for slow growth companies.  Peter Lynch has proposed a 1:1 relationship.  In other words, a PE of 15 suggests an EPS growth rate of 15% each year.  A high PE of 100, suggests an annual EPS growth rate of 100%, and so on.  Peter Lynch suggests this relationship as a rule of thumb.  The take home message is the appears to be a relationship between the PE ratio and anticipated growth in EPS.High PE ratios are not sustainable.  A high PE suggests rapid advancement.  Rapid growth cannot be sustained for ever.  Let’s say a company has one million dollars in revenues and a top line growth rate of 100% for the past two years.  If the market awards the company a PE of 100 (bids the price per share up so high that the PE is 100), it suggests that within ten years, sales will be $1 billion.   Further, within 20 years, the company could be 20% of the total economy—within 25 years, the revenues of the company would be double the GDP of the United States!  High PE’s, like high growth rates, are not sustainable.Finally, there is another ratio called the PEG ratio—PE to growth ratio .  The PEG ratio is the PE ratio divided by the annual EPS growth rate.  This time you make an exception to the rule I described earlier: the growth rate is expressed as a percentage.  For example, if the PE is 30 and the earnings are growing at 15% each year, the PEG is 2 (30 ¸ 15 = 2).  You’ll see the PEG ratio discussed in some financial publications.  If the company is solid, and the PEG ratio is low (less than 1), it means that you could be buying a growing company at a discount.  Some people believe in using the PEG ratio in a ‘screen,’ a good way of finding undervalued companies.Finishing off Section 3Below is a copy of section 3 of the SSG for Clayton Homes. Let me run through section 3 step by step—we have a lot of the ground work completed above—I mean a lot J!First off, you enter the present price—the price as of the date you complete the SSG, then the high and low for the year.  You can tell immediately if the stock is near to the price extremes witnessed in the past twelve months or so.  By the way, you get the high and low from the price banners on the Value Line.OK, now some more work.  We’re going to collect information for five years—it all comes from the Value Line survey.  You’re going to need to find the following, so pull out the Value Line now and identify where the information is:1.    The high and low stock price for each of the past five years2.    EPS for each of the past five years3.    The dividend paid for each of the past five yearsThat’s it!There’s really not a lot of work to be done.  Look at the blank SSG.  The rows, just under the word “Year” are numbered 1 through 5.  Row 5 is the most recent year.  For this example, the last full year of information is 1999.  So, row 1 is then 1995.  You enter the years—1995 to 1999—on rows 1 to 5.The next series of columns are identified as ‘A’ through ‘H.’  Column A is the high price.  The high price for each of the past five years is entered.  The low price is entered into column B.  The five low prices are added together; the sum is written just below the low for 1999; this number is divided by 5 to give the average; the average is written below the sum.  Finally, the EPS is written in column C.  EPS, like the stock prices, is found in Value Line.Columns D and E are PE ratios—something with which you’re now familiar.  The columns record the high and low PE ratios for each of the past five years.  Since the PE ratio is nothing more than the stock price divided by the earnings pre share, it changes each time the stock price changes.To get the high PE you divide the high price in column A by the corresponding EPS value in column C—the result is written into the appropriate box in column D.  For example, in 1997 the high price was 15.6 and the EPS was 0.80, so the high PE ratio is 15.6 ¸ 0.80 = 19.5You do the exact same thing for the low PE, except you now divide the low stock price for the year by the EPS for that year.  Once the high and low PE ratios are calculated, you calculate the average high and low.  Just repeat the steps for calculating the average low price: sum the numbers up and divided by 5.  These high and low PE values will be featured later on when we examine the Portfolio Management Guide and PERT-A.I want to make one comment about Value Line and the way data are reported.  The financial information for each company is reported on a fiscal year basis.  For example, Clayton Homes has a fiscal year that ends of June 30, so the numbers in the statistical array reflect that fact.  However, the stock prices are based on a calendar year.  Ideally, you want to use fiscal year stock prices.  Here’s why.If your company grows steadily, the stock price should grow too.  Let’s say the fiscal year is January 31.  There’s another 11 months each calendar year when the stock price could grow to mirror the EPS increases each quarter.  The stock price high and low will reflect quarterly EPS values—the rolling four quarters of earnings will be higher than the fiscal year number.  The result is that the high and low PE will look higher than they should.  If a company you analyze appears to have a higher PE than competitors, it may be a reporting issue—fiscal versus calendar year.In column F, you list the dividends paid for each of the past five years.  Then in column G, you divide the dividend by the corresponding EPS number (in 1995: 0.03 and 0.59, respectively) and multiply the result by 100.  You’re calculating the percentage of the EPS that get paid to shareholders as a dividend. Finally, in column H, you’re going to calculate a yield—a dividend yield.  The dividend yield is a pretty easy concept.  I’ll illustrate by example.  In 1995, the stock price ranged from $6.80 to $15.0 a share; the company paid a dividend of $0.03—that’s 3¢!  You’re calculating your return.  If you’re investing $6.80 and you get three cents back a year, what’s the return? You’re getting a 0.4% return (or there about!); if you bought when the stock price was its most expensive, your return would beThe percentage is called a yield—what you get back.  Clearly you get a higher yield when the stock price is low: you’re paying less money for the same dividend!  Column H wants the high dividend yield for the year.  Clearly, the highest yield occurred when the price was lowest.  The yield is obtained by dividing the low share price into the dividend and multiplying the result by 100%.  The yields are listed in the appropriate spot in column H.On row 8, you calculate two things.  First, the average PE ratio for the past five years is obtained by taking the average high (19.8) and the average low (11.4), adding them together and dividing by two.  The current PE ratio is calculated by getting the past four quarters of earnings from Value Line.  Adding those four numbers together to gives an annual EPS.  Dividing this annual EPS ($1.12 in our example) into the current share price of $9.00 produces a PE ratio of around 8.  Now you know who to calculate a PE ratio; next we discuss how they behave.Trends in the PE RatioPE ratios tend to move in cycles.  They tend to “expand,” that is increase, in good times and “contract,” decline, in bad times.  PE ratios appear to correlate a little with interest rates too—whatever the Federal Reserve is up to.  I’ll talk about interest rates first.There are probably two things that drive a stock price—supply/demand and the fundamentals.  In reality, it’s really all about supply and demand.  Here’s why.  If interest rates are low, then bond yields (interest rates on bonds) tend to be low too.  Investors always have a choice among a myriad of financial instruments; however, the choice is usually described as being between stocks and bonds—those are the two big categories of securities.  If the interest rates on bonds are very low, then more people might be coaxed into buying stocks.  Let’s face it, if you get a poor return, you’re likely to go shopping for an asset that will do better!  Let’s face it, if you get a poor return, you’re likely to go shopping for an asset that will do better!  When this phenomenon occurs, the number of dollars searching to buy stocks increases, while the number of shares of companies available for sale remains pretty constant.  Hence, if “demand is greater than supply,” the price of the average stock trends up.  If prices go up, so too does the average PE ratio.  Conversely, when interest rates on bonds and other “fixed” securities rise, more people are enticed into buying these instruments.  They tend to forego stocks for bonds, which are viewed as more secure.  Therefore, if the number of shares for sale remains the same, and there are fewer people—fewer investing dollars—in search of equity, the average price of a share falls.  When prices fall so too does the PE ratio (assuming that EPS remains reasonably unaffected).  In summary, when interest rates fall, stock prices (and PE ratios) rise; when interest rates rise, stock prices (and PE ratios) fall.Interestingly, Clayton Homes seems to be trending in the other direction!  Well, the statements above are only a rule of thumb.  As discussed previously, a PE ratio also says something about anticipated growth in EPS.  If the PE is high, it means people—on the average—are expecting the EPS to rise aggressively.  When the PE is low, they’re expecting growth that’s slow.  Remember, the stock market is a voting machine in the short run; the PE shows how opinions about a company change over time, even if nothing is fundamentally different with that company!  The PE ratios—both high and low—for Clayton Homes have been trending down.  You often want to follow, or at least acknowledge, a trend.  We’ll talk about this topic in the next section.Projected and current PE ratioWhen section 3 is completed using Toolkit, you notice that current and projected PE ratios are given.  The current PE ratio is calculated by dividing the current price—$9.00 in our example—by the current earnings.  The current earnings are calculated by adding together the results for the past four quarters.  This result is $1.12, so $1.12 is divided into $9 to give a current PE ratio of 8.The projected PE ratio is calculated by taking the most recent four quarters of earnings—that’s $1.12—and then projecting them four quarters into the future.  Now remember, in this example, the preferred procedure was used to calculate the EPS for year 5.  This procedure gave earnings in year 5 of $2.37.  If earnings grow from $1.06 to $2.37 in five years, it suggests an annual rate of compound growth of 17.4%.[1]  So, if you project the most recent four quarters of earnings, $1.12, to grow by 17.4% you get a result of $1.31.  The current stock price is $9, so the PE ratio based on projected earnings (projected PE ratio) is $9 divided by $1.31, which gives a PE of 6.84, that’s approximately 6.8.So, you’re asking—why is this guy looking at a projected PE ratio, what’s going on here? When you look at the numbers in Value Line, you’ve got the earnings for a complete year.  Combined with the stock price, you get a high and low PE for that year—you’re looking back.  (I know that the fiscal year/calendar year mix up spoils things a little).  With the projected PE ratio, what you’re saying is “if I could look back twelve months from now, what would today’s PE look like?”  You’re looking back with earnings (projected) 12 months in the future.  You’re trying to transport yourself forward to where Value Line would have you 12 months from now.  What does today’s stock price look like, if you could look back at it from the vantage point of a year from now.  That’s the projected PE.  With a projected PE of 6.8, we’re even lower today than the average low PE.  In fact, we’re lower today than any of the low PE’s for the past five years!ReviewA lot of ground has been covered in this chapter.  We’ve examined indicators of good management.  We’ve investigated these indicators in detail.  We’ve tried to get a handle on the historical price range of the company stock and introduced a term called PE to show what is paid for earnings. Questions  1. In section 2 of the SSG, you calculate(a)    net profit margin and ROE(b)   pretax profit margin and ROE(c)    dividends earned and pretax profit margin(d)   aftertax profit margin and ROE(e)    cash flow per share and ROE2. Another way of looking at return on equity is the(a)    return on assets(b)   return on long-term debt(c)    return on net sales(d)   return on net assets(e)    return on net income3. Ideally, the pretax profit margin should be(a)      decreasing slightly or stable(b)     increasing or decreasing slightly(c)      greater than 15%(d)     stable or increasing slightly(e)      equal to the EPS growth rate4. The ROE is(a)    always greater than the pretax profit margin(b)   never greater than the pretax profit margin(c)    used to tell something about company management(d)   the growth rate of the company asset base(e)    none of the above 5. Which of the following was stated in the text(a)    the pretax profit margin and ROE should track(b)   if the ROE increases, the pretax profit margin should decline(c)    if the pretax profit margin increase, ROE should decline(d)   ROE should always be greater than the pretax profit margin(e)    the difference between ROE and pretax profit is due to dividends6. When calculating EPS with the preferred procedure, each of the following is used, except(a)    preferred shares outstanding(b)   a pretax profit margin(c)    a tax rate(d)   the number of shares outstanding(e)    the future sales7. The preferred procedure is used because(a)    sales tend to be unstable(b)   it is generally within 2% of the actual answer(c)    cash flow is another form of EPS(d)   EPS is very predictable(e)    sales are often more predictable than earnings8. EPS is calculated using(a)    pretax profit and issued shares(b)   gross income and outstanding shares(c)    net income and issued shares(d)   EBIT and outstanding shares(e)    net income and outstanding shares9. If the ROE is broken up you get(a)    the components of the preferred method(b)   a driver for profitability, efficiency and dividend policy(c)    a driver for inventory management, asset utilization and profit(d)   a driver for profitability, efficiency and leverage(e)    none of the above10. Each of the following is true except(a)    The ROE is industry specific(b)   Different industries have different rates of leverage(c)    The ROE is always greater when companies have tangible assets(d)   Pretax profit margin is often the most important driver in ROE(e)    Some companies have negative profit margins.11. Section three of the stock selection guide is used(a)    as an indicator of future revenue growth(b)   to predict the ROE(c)    to study the PE ratio(d)   to determine the total return(e)    none of the above12. PE stands for(a)      profit extracted(b)     pretax earnings(c)      price earnings ratio(d)     published earnings(e)      earnings per share13. The PE ratio is calculated using(a)    a stock price and net income(b)   a stock price and EPS(c)    EPS and a profit margin(d)   the ROE time pretax profit(e)    none of the above14. When talking about the PE ratio, Peter Lynch believes(a)    it is always reasonable(b)   it has little value(c)    it should correlated with the EPS growth(d)   it is a measure of free cash flow(e)    none of the above15. The payout ratio is(a)    the dividend that’s paid in cash(b)   the dividend divided by a share price(c)    EPS divided by a share price(d)   a share price divided by EPS(e)    the percentage of EPS paid out as a dividend16. PE ratios can be affected by(a)    supply/demand issues but not interest rates(b)   interest rates but not supply/demand issues(c)    supply/demand issues and interest rates(d)   neither supply/demand issues nor interest rates(e)    none of the above17. In the SSG, which of the following was calculated(a)    the projected, but not the current PE ratio(b)   the projected and the current PE ratio(c)    the current but not the projected PE ratio(d)   neither the current nor the projected PE ratio(e)    none of the above 18. The dividend yield is(a)    the payout ratio times EPS(b)   dividend per share divided by PE ratio(c)    dividend per share divided by a share price(d)   the share price divided by the EPS(e)    the dividend per share divided by EPS19. Which of the following was described as the hallmark of a “good” company?(a)    steady growth in sales(b)   steady growth in earnings(c)    stable or growing pretax profit margin(d)   stable or growing ROE(e)    all of the above20. To calculate pretax profit on revenues, the following information is required(a)    tax rate, EPS, shares outstanding(b)   tax rate, revenues, and EPS(c)    EPS, outstanding shares and growth rate(d)   tax rate, pretax profit and revenues(e)    pretax profit, revenues, EPS Next >