| The price/earnings ratio is often used as a tool for deciding whether to invest in a company. This ratio (also called the P/E or multiple) is obtained simply through dividing a stock’s current price by its earnings per share. A high P/E is considered by many analysts as an indication that a stock may be overpriced. It used to be that a P/E over 20 was considered a possible danger sign. However, in these days of inflated Internet stock prices, some gurus are recommending the purchase of stocks with multiples in the hundreds! Of course, you should always use more than one yardstick in evaluating a company anyway.
Two other figures frequently used to measure the desirability of a stock are the company’s price-to-sales ratio and the price-to-book ratio.
The price-to-sales ratio is computed by first calculating the current market capitalization of the company. You get that by multiplying the stock price by the number of shares outstanding — in other words, held by shareholders, a figure you can find on corporate balance sheets under the heading capital stock issued and outstanding.
Okay, now that you have the market capitalization, you divide that number by the company’s annual revenue. The result is the price-to-sales ratio, also called the PSR. A PSR of one would indicate to investors that they’re paying $1 for every dollar of company sales, a very promising indicator. A company with a low PSR is considered undervalued and, therefore, a good investment.
Sales figures are usually considered more reliable than earnings reports, because a company’s accounting department can do some juggling of the books to make earnings look higher—such as shifting certain expenses to a future quarter. On the other hand, the company can’t claim sales it doesn’t have — unless it really wants to get into trouble with the regulating bodies.
The PSR is a good tool to use in evaluating those pesky Internet stocks, particularly those of companies that have been in business for years with no earnings as yet. Look for companies with a low PSR plus a record of a year or more of increasing sales.
The price-to-book ratio (P/B) is a measurement tool that can be quite helpful in determining the status of companies with a lot of assets on the books. However, those Internet startups, other software companies and service businesses of many kinds may be harder to judge with price-to-book. The reason is that this yardstick does not rate intangibles such as the worth of key employees, people under contract, patents, and goodwill.
You figure price-to-book by dividing a company’s stock price by its book value per share. Value per share is based on an estimate of what that value would be if the company were liquidated. If you have a copy of the company’s balance sheet, you can figure book value by merely subtracting liabilities, then also subtracting all those intangible assets from the total assets listed.
So after you’ve divided the stock price by the book value, what do you do with the result? Of course, you can compare the figure with the particular company’s price-to-book ratio in previous years. You can also check it against industry averages. In 1991 the average P/B ratio for the stocks in the Standard & Poor’s 500 was 3.14, for example; in 1998 that figure jumped to 6.36. A ratio of 5 or more is normally considered high. The usual range is 1 to 5. A low P/B is often viewed favorably because, as an investor, you’re paying less for the earning power of the company’s assets.
One cautionary note: As we’ve explained, book value is an integral part of the formula for determining P/B. Unfortunately, as is the case with earnings, accountants can easily play with the elements that constitute book value to suit their goals, through the use of write-offs and changing their valuation of real estate and inventory.
When you look for information about a specific company on the Internet, some financial sites show P/E, PSR, and P/B already calculated for you. All you have to do—as a cagey investor—is evaluate the ratios before you part with your money.
GLOSSARY:
• Price-to-Book ratio (P/B). A stock’s current price divided by its book value per share. Also called market-to-book.
• Price/earnings ratio (P/E). A stock’s current price divided by its earnings per share. Also called a stock’s multiple.
• Price/sales ratio (PSR). A stock’s current market capitalization (its price per share multiplied by the number of shares outstanding) divided by the company’s annual revenue.
• Standard & Poor’s 500 index. Commonly called the S&P 500. A measurement of changes in stock market conditions based on the average performance of the stocks of 500 major corporations. | 