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Indicators of a stock's value

By David Luhman on Sun, 05/10/2009 - 00:49

Indicators of a stock's value

The P/E Ratio

The price to earnings ratio for a stock is a good indication of the relative attractiveness of the stock. A price to earnings ratio of 10 means that investors are willing to spend $10 to buy $1 worth of earnings generated by the stock.

In comparison, a stock with a price to earnings ratio of 20 means that investors are willing to pay twice as much for the same $1 of earnings. Different stocks have different P/E ratios. An older, more established company may have a P/E ratio of 10, while a smaller, growing company may have a P/E of 20.

Why the discrepancy? The investor who buys the smaller company knows that, for now, her investment buys only half the earnings "bang for the buck" of the larger company. But she hopes that the smaller company's earnings will grow faster than the larger firm's earnings and thus justify the higher relative price.

Earnings yield

Another way to think of the price to earnings ratio is to look at the inverse of the P/E ratio, the so-called earnings yield. I prefer this approach, because it allows you to compare yields on a stock with the yield you might get on a bond.

If a stock has a P/E ratio of 10, the stock has an earnings yield of 10 percent. This would probably compare well with a bond that is paying interest at 7 percent. In this case, the stock has a higher earnings yield than the bond's interest yield.

But the earnings yield is different from the interest yield you receive from a bond. If a bond yields 7 percent, for every $100 you invest you can expect interest payments that will total $7 over the course of a year.

However, if a stock has an earnings yield of 10 percent, you almost certainly won't get $10 in payments per year for every $100 you invest. In fact, you'll be lucky if you get half of that, and you may not get any current income from the stock.

Dividend payout ratios

The reason is that companies reinvest most or all of their earnings. They don't give all their earnings to their shareholders. In fact, many small growth companies don't give any of their profits to their shareholders.

Instead of kicking their profits out to their shareholders, these small companies reinvest their earnings to buy more equipment and hire more people.

Larger companies, however, realize that their market isn't growing very fast, so they decide to distribute some of their profits to their shareholders by paying them quarterly dividends.

Utilities have high payout ratios

A New England electric utility is a good example of a company that probably will distribute most of its profits to shareholders because of limited growth prospects. The utility will see limited population growth, and it's unlikely that people suddenly will want to double their consumption of electricity, so the utility doesn't need much money for expansion.

So the utility may pay out 70 percent of its earnings in the form of dividends. This 70 percent is called the payout ratio. Payout ratios of 70 percent are common for utilities, while payout ratios for most large, blue chip companies are perhaps 30 percent.

Small firms have low payout ratios

On the other hand, small computer companies probably will have a payout ratio of zero in their early years. As the company matures, it may start paying a small dividend, and the payout ratio may rise to 10 percent after a few years.

Companies with high payout ratios tend to have high dividend yields. The dividend yield is the number which is more comparable to the yield you'll receive from a bond, because the dividend yield reflects the actual quarterly dividends that you'll receive from the company.

If you pay $100 for a share of stock that has a dividend yield of 4 percent, you can expect to get four quarterly dividend checks of $1 from the company.

Because of its direct comparability to the yield on a bond, I think that the dividend yield is an important number.

In fact, if you take the current dividend yield of the Standard & Poors 500 stocks and double it, you'll get a good estimate of the average annual total return for the stock market over the next five to 10 years. This works because, for the stock market as a whole, half of your return comes in the form of dividend income and half in the form of capital gains.

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