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(Peter Power)
(Peter Power)

Investor Clinic

The 1-2-3s of ratios for investors Add to ...

Ratios are an indispensable part of everyday life. For instance, when you make a martini (four parts gin, one part vermouth) or place a sports bet (the Oilers are a 100:1 shot to win the Stanley Cup), you're using ratios.

When it comes to stocks, however, many retail investors develop a case of ratio-phobia. All those numbers seem so complicated! You need a PhD in finance to understand what they mean!

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No, you don't. All you need is this edition of Investor Clinic. We'll look at a few of the most basic investing ratios, starting with the price-to-earnings ratio.

THE P/E RATIO

Take the current stock price. Now, divide it by the company's annual per share earnings. Voilà: That's your price-to-earnings ratio. For example, if a stock is trading at $10, and the company made $1 in annual profit, the P/E is 10. If the stock trades at $50 and profit is $2, the P/E is 25. In other words, the P/E shows how much investors are willing to pay for $1 in earnings.

Where P/Es get a bit tricky is the E part of the equation. In some cases, the E refers to earnings over the previous 12 months. In others, it refers to projected earnings over the next 12 months, or the next fiscal year. To confuse things further, the E may or may not include one-time items such as restructuring charges.

Let's look at a real-life example. Telus Corp. posted profit of $3.12 over the previous four quarters, and its stock closed yesterday at $44.75. Its trailing P/E multiple is therefore $44.75/$3.12 or 14.3. Based on Telus's estimated profit of $3.50 in fiscal 2011, the stock is trading at a forward P/E multiple of 12.8

Typically, the stock market will accord a higher P/E to a company whose earnings are growing faster, and a lower P/E to one whose earnings are growing more slowly.

The danger with high P/E stocks is that the lofty expectations built into the share price may not materialize, sending the stock south in a hurry. The danger with low P/E stocks is that the company may be facing competitive or financial challenges, which is why the market gives them a low multiple.



Learn more about investing from John Heinzl The 2010 Investor Education series for beginner investors:

  • Part 1: Want to invest? Learn to save first
  • Part 2: Mutual funds: A good place to start
  • Part 3: Why ETFs are booming
  • Part 4: Sleeping well with GICs
  • Part 5: Why buy and hold is (still) the best approach
  • Part 6: Death, yes. Taxes? Not necessarily.


THE PEG RATIO

The PEG ratio takes the P/E one step further by factoring in the company's earnings growth rate. To calculate the PEG, divide the P/E ratio by the company's projected growth rate over the next one to five years.

The PEG ratio is just a rule of thumb. It was popularized by legendary U.S. fund manager Peter Lynch, who said in his book One Up on Wall Street that "the P/E ratio of any company that's fairly priced will equal its growth rate." In other words, investors should look for companies with a PEG of one or less.

As an example, a company with a P/E of 20 and a projected earnings growth rate of 25 per cent over the next several years would have a PEG of 20/25, or 0.8. The PEG ratio, of course, is only as good as the earnings projection. Analysts are notoriously bad at predicting where earnings are heading in one year, let alone three or five years.

THE EARNINGS YIELD

The earnings yield is the P/E ratio flipped on its head. It's the company's annual earnings per share, divided by the share price. Example: If a stock is trading at $20 and the company makes $1.50 a share in annual profit, the earnings yield is $1.50/$20 or 7.5 per cent. In other words, the earnings yield shows how much profit a company generates relative to the price investors are willing to pay for its shares.

Some investors - notably Warren Buffett - like to compare a stock's earnings yield to the yield on government bonds. The earnings yield should be higher - usually substantially higher - to compensate for the additional risk of owning equities. For example, the earnings yield on Bank of Montreal is currently about 8.1 per cent, based on estimated fiscal 2010 earnings. That compares with a yield of less than 3 per cent on Government of Canada bonds.

It's important to remember that the earnings yield doesn't measure the investor's actual return. Companies may reinvest all of their profits in the business or pay out a portion to shareholders, so the earnings yield will usually differ from the dividend yield, which is our next ratio.

THE DIVIDEND YIELD

This is the annual dividend paid by a company, divided by the current stock price.Example: Say you bought a stock for $25 that pays $1 in annual dividends. Your dividend yield would be $1/$25 or 4 per cent.

Simple enough. Where people get tripped up is that the dividend yield is always changing.

Say the stock climbs to $30, but the annual dividend remains at $1. The dividend yield would therefore be $1/$30, or 3.33 per cent. If the stock price falls to $20, the dividend yield would be $1/$20, or 5 per cent. See a pattern here? The dividend yield falls as the share price rises, and vice versa, as long as the dividend itself stays the same.

What if the dividend changes? Just divide the new annual dividend by the current stock price, and that's your new dividend yield. Typically, the dividend yield quoted in newspapers and on websites is what's known as the indicated yield. It's based on the projected annual dividend over the next year, which is usually the most recent quarterly dividend multiplied by four.



Watch Investor Clinic videos:

  • Why I love dividend growth stocks
  • The right way to approach tax-loss selling
  • What's an MER?
  • ETFs: What could go wrong
  • How to pay less tax
  • Dividend stocks, your friend
  • Why dividend ETFs will make you richer
  • The right way to approach tax-loss selling
  • Coping with volatility
  • Dividend dates explained
  • GIC rates: Creeping higher
  • Joy of dividends
  • Fund fees hurting?




Follow on Twitter: @johnheinzl

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