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