Indicators of a Stock's Value

Indicators of a Stock's Value

Can a high P/E ratio ever be justified?

How do earnings and dividends compare?

The stocks that have the highest payout ratios -- and the lowest!

Can a high P/E ratio ever be justified?

A price-earnings (P/E) ratio is a good indicator of a stock's value

If indicates how much investors are willing to pay for $1 in earnings

If a stock sells at $20, and the company earns $1 per share, the price to earnings ratio is 20

The higher the P/E ratio, the more speculative the stock

A high P/E ratio can be justified if the stock is growing rapidly

Generally the growth rate should be higher than the PE ratio

A company that is growing at 30 percent a year may be a bargain if the company's P/E ratio is 25

How do earnings and dividends compare?

Aside from the P/E ratio, here's another way to look at a stock's value

Look at the company's earnings yield and dividend yield and compare these to bonds

Earnings yield is the inverse of the P/E ratio

If a company has a P/E ratio of 10, the earnings yield is 10 percent

This would probably compare favorably with a long-term bond yielding 7 percent interest

The dividend yield is even more directly comparable to bond yields

Dividends represent actual cash paid out to shareholders, much like bondholders who receive interest

If a stock costs $20 and pays out $1 in dividends a year, the dividend yield is 5 percent

This would also compare favorably with a long-term bond

Bond yields 7 percent but offers no potential for growth

Stock has only 5 percent dividend yield, but offers potential for dividend growth

The stocks that have the highest payout ratios -- and the lowest!

The payout ratio shows what percentage of its profits the company is distributing to its shareholders

Example

A company earns $1.00 a share annually

If it pays out $0.15 each quarter in dividends, the payout ratio is 60 percent

Annual dividends = $0.60

Payout ratio = $0.60 / $1.00 = 60 percent

Small growth companies reinvest their earnings to further grow the business

These firms have payout ratios near zero

Large, stable companies like utilities pay out most of their earnings to share holders

Utilities may pay out 75 percent of their profits as dividends

Most other large firms have payout ratios of around 40 percent