Common Stock Price Ratios
Common stock price ratios provide information about a company’s
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
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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