Common Stock Price Ratios

Common stock price ratios provide information about a company’s stock price.

The Price/Earnings (P/E) Ratio
The price/earnings ratio is a measure of how the market prices a company’s stock. The most commonly used guide to the relationship between stock prices and earnings is the price/earnings (P/E) ratio, which is calculated as follows:

Price/earnings ratio = market price of the stock/earnings per share

The P/E ratio shows the number of times that a stock’s price is trading relative to its earnings. The P/E ratios for listed common stocks are published daily in the financial newspapers and on financial Web sites. For example, the P/E ratio for Cisco Systems as of September 26, 2006, was 26.4 ($23.50/$0.89), with a market price of $23.50 per share and trailing earnings per share of $0.89 per share. This number indicates that shareholders were willing to pay 26.4 times Cisco’s earnings for its stock. Put another way, it would take 26.4 years of these earnings to equal the invested amount ($23.50 per share). P/E ratios also can be computed on expected or future earnings. Cisco’s forward earnings per share are projected to be $1.47, resulting in a forward P/E ratio of 15.99 ($23.50/$1.47).

Acompany’s P/E ratio shows how expensive its stock is relative to its earnings. Companies with high P/E ratios (higher than 20 as a general rule) are characteristic of growth companies. Although with the average market multiple around 17 (in September 2006), a forward P/E ratio of 15 for Cisco makes it almost seem like a value stock. Investors might be optimistic about a company’s potential growth, and hence the stock price is driven up in anticipation. This situation results in a high stock price relative to the company’s current earnings. Some investors might be willing to pay a high price for a company’s potential earnings; other investors might consider these types of stocks to be overpriced.

What becomes apparent is that high P/E ratios indicate high risk. If the future anticipated growth of high P/E ratio stocks is not achieved, their stock prices are punished, and their prices fall quickly. On the other hand, if they live up to their earnings expectations, investors benefit substantially. A low P/E ratio stock (<10) is characteristic of either a mature company with low growth potential or a company that is undervalued or in financial difficulty. By comparing the P/E ratios of companies with the averages in the industries and the markets, you can get an idea of the relative value of the stock. For example, the average P/E ratio for companies on the U.S. stock markets was around 17 times earnings in September 2006. During bull markets, the average ratio goes up, and during bear markets, the average declines (perhaps as low as six times earnings, which happened in 1974).

P/E ratios fluctuate considerably, differing among companies as a result of many factors, such as growth rates, earnings, and other financial characteristics.

Earnings per Share
The earnings per share (EPS) figure for a company is the amount of reported income on a per-share basis. The earnings per share indicate the amount of earnings allocated to each share of common stock outstanding. EPS figures can be used to compare the growth (or lack of growth) in earnings from year to year and to project future growth in earnings.

Earnings per share = (net income – preferred dividends)/ number of common shares outstanding

The number of shares outstanding equals the number of shares issued minus the shares that the company has bought back, called treasury stock. In many cases, companies report two sets of earnings per share, regular earnings per share and fully diluted earnings per share.

When companies have convertible bonds and convertible preferred stock, rights, options, and/or warrants, their EPS figures may be diluted because of the increased number of common shares outstanding, if and when these securities are converted into common stocks. Companies are then required to disclose their fully diluted EPS figures and their basic earnings per share.

Earnings per share that are increasing steadily because of growth in sales should translate into increasing stock prices. However, earnings per share also can increase when companies buy back their own shares. The number of shares outstanding is then reduced, and if earnings stay the same, the earnings per share increase. Conceivably, earnings per share can increase when sales and earnings decrease if a significant number of shares are bought back. Astute investors examine a company’s financial statements to determine whether the increase in earnings per share is caused by a growth in sales and earnings or by stock buybacks. If the latter is true, the result can be a loss of confidence in the stock, which can lead to a decline in the stock price.

Companies with poor fundamentals may try this tactic of buying back their shares to improve their earnings per share and ultimately their stock prices, but this strategy may not work over the long term.

The earnings per share also can be determined as follows:
Earnings per share = market price of the stock/P/E ratio

Dividends and Dividend Yields
Investors buy stocks for their potential capital gains and/or their dividend payments. Companies either share their profits with their shareholders by paying dividends or retain their earnings and reinvest them in different projects to boost their share prices. Look in the financial newspapers or use the Internet to find the dividend amounts that listed companies pay. Companies generally try to maintain their stated dividend payments even if they suffer declines in earnings. Similarly, an increase in earnings does not always translate into an increase in dividends. Certainly, many examples exist in which companies experience increases in earnings that case. An imprecise relationship exists between dividends and earnings. Sometimes, increases in earnings exceed increases in dividends; at other times, increases in dividends exceed increases in earnings. Thus growth in dividends cannot be interpreted as a sign of a company’s financial strength.

Dividends are important because they represent tangible returns. In contrast, investors in growth stocks that pay little or no dividends are betting on capital appreciation rather than on current returns.

The dividend yield is a measure of the annual dividends a company pays as a percentage of the market price of the stock. This ratio shows the percentage return that dividends represent relative to the market price of the common stock.

Dividend yield = annual dividend/market price of the stock

In an extended bull market, many investors are nervous about growth stocks that either pay no or low dividends and turn to stocks that yield high dividends. A strategy of buying this type of stock might offer some protection against the fall in stock market prices owing to rising interest rates. Dividend yields of many utility companies, real estate investment trusts (REITS), and energy companies might be as high as 4 to 7 percent. High dividend yields are characteristic of a few blue-chip companies and the utility companies.

Choosing stocks purely because of their high dividend yields, however, is risky. Dividends always can be reduced, which generally puts downward pressure on the stock price.

When you are choosing stocks with high dividend yields, you should look at the stocks’ earnings to ensure that they are sufficient to support the dividend payments. As a general rule, earnings should be equal to at least 150 percent of the dividend payout. The dividend payout ratio is the percentage of earnings a company pays out to its shareholders in dividends.

Dividend payout ratio = dividend per share/earnings per share

In addition to looking at earnings, you also should look at the statement of changes in cash to see the sources and uses of cash. For example, if the major sources of cash come from issuing debt and selling off assets, a company cannot maintain a policy of paying high dividend yields.

Dividends and dividend yields are not good indicators of the intrinsic value of a stock because dividend payments fluctuate considerably over time, creating an imprecise relationship between the growth in dividends and the growth in earnings.

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