A Better Grade in P/E
The price/earnings ratio has long been a popular tool for stock pickers. Here's how to sharpen it.Pop Quiz: How do you Calculate a price/earnings ratio? That might seem too simple, but I can think of more than a dozen answers. Divide a company's stock price by a year's worth of its earnings; That's the straightforward answer. To do this, however, we must first decide which year and which earnings. There's the calendar year, fiscal year, and closest four quarters. For each we can look backward at published results, which are reliable buy not especially fresh, or ahead to forecasts, which are fresh but not always reliable.
For earnings, should we use the measure companies must report, or the one Wall Street perfers to talk about? The first measure--GAAP ( or generally accepted accounting principles) earnings - is sometimes rendered nonsensical by onetime charges related to past endeavors, while the second measure - adjusted or operating earnings - includes only current business results. The second measure sounds fairer, but some companies present "onetime" charges all too frequently, and besides, even charges that don't relate to current decisions still reflect the sum of past ones.
Already, without getting into the nitty-gritty, we have a dozen possible combinations for our P/E. No wonder many investors who screen for stock bargains rely on less slippery measures than earnings: sales, which aren't blemished by accounting charges; the book value of assets, which tends to change slowly; and dividends, which company managers declare in advance.
Don't give up on P/E ratios, though. Price and earnings are two of the most useful things to know about a company. The dky to getting P/Es to tell the truth is to make sure they reflect normal results, not ideal ones.
One way to do that for the broad stock market is to adjust earnings for swings in the business cycle. Standard & Poor's 500 index recently traded at 20 times trailing operating earnings, but that doesn't tell us if the trailing year was normal. The index's earnings are down just over 30 percent from two years ago - so are they too slim now, or were they too puffy then? Yale economics professor Robert Shiller likes to use a 10-year average of index earnings to smooth out the swings. By his math, U.S. stocks are now trading at 21 times earnings, versus an average of 16 since 1881. That is, they're a bit pricey.
Sometimes an entire decade of earnings can mislead, so rather than use a 10-year P/E, I like to adjust the market's current P/E for the nations profit margin, so to speak. That's America's corporate earnings as a percentage of its gross domestic income, as reported by the Bureau of Economic Analysis. The average profit margin since 1929 is 4.8 percent, so although corporate profits are lean relative to recent history, they're slightly plump compared with those of the past eight decades. If anything, we should inflate the market's P/E a smidgen to adjust. (As it turns out, that gets us pretty close to Shiller's 10-year P/E of 21.)
Those tricks are useful for judging the broad market, but they're less useful for single companies. Averaging 10-years of earnings would ignore that companies change, often sharply, as they grow (or shrink). To judge individual companies, start by being wary of ones whose adjusted or operating earnings are consistently much larger than their GAAP earnings. This phenomenon is quietly becoming an epidemic. Next, watch out for companies whose earnings consistently dwarf their free cash flow. Mature companies should collect real cash and not just report paper profits. When free cash flow is larger than earnings, on the other hand, it's often a sign that earnings are about to rise and the stock is set to outperform, studies show.
To select the five companies below, I searched the S&P500 for firms whose adjusted earnings weren't much larger than their GAAP earnings in recent years. I also looked for those that had recently produced more free cash than earnings. That left just over 170 companies, and only 68 that have increased their sales during the past year. Analysts expect these companies to increase their adjusted earnings by a median of 25 percent in the next four quarters, which is too optimistic for my comfort. So I averaged trailing earnings with forecasted ones and used the result to calculate my P/Es. The result was a median of about 17; the companines that follow have P/Es of 12 or below (the lower the number the better).
Forest Laboratories has a low P/E ratio for good reason. More than half of its sales last year came from Lexapro, a depression pill that will face generic competition in 2012 (know about the business and how the company makes its money). One analyst recently called that a patent apocalypse, but Forest should be okay. The company holds cash equal to more than one-third its stock value, has seven drugs in late-stage trials and has been aggressively licensing new products.
GameStop, one of the cheapest stocks on the list, increased its sales an estimated 2 percent during the past year. Its profit margins are much larger than those of many other retailers, in part because GameStop does a lucrative trade in used games, yet the stock fetches less than one-third its Christmas 2007 price. That's because the company used to increase its sales by more than 20 percent a year (know how the company makes its money). It's now a stalled and abandoned growth stock, but those sometimes make excellent value stocks.
Hearlth-Insurance stocks hot a lift late last year (2009) after Congress turned away from proposals to let government compete against insurers and instead began to focus on whether the uninsured should be required to buy private coverage (Since this was written, The court in Virginia in 2010 said that Congress overstepped their authority in requiring the purchase of anything by citizens). Share prices are still modest relative to profits, however. Aetna handles mostly workplace plans, and so has lost members to unemployment, but premium increases have kept profits and cash flow plentiful. Last year (2009); the company repurchased about 6 percent of its outstanding shares.
The U.S. Department of Defense's budget, including supplemental spending, is expected to remain flat through 2015. That's why L-3 Communications Holdings, a Manhattan buyer of companies involved with spy systems, warfare electronics, military services and aircraft maintenance, trades at a steep discount to the broad stock market. But its annual sales and profits are increasing, and the company yearly produces free cash that amounts to more than 10 percent of its stock market value, making its 1.7 percent dividend yield look affordable, even stingy.
Finally, Western Digital makes and sells computer hard drives. After a year of industry downsizing, inventories are lean, selling prices are stable, and demand is picking up. In fact, analysts say growth this year will be constrained only by supply with component makers operation at full capacity. Western Digital has about $2 million in net cash, equal to more than 20 percent of its stock market value.
Mind the Bottom Line
The key to getting price/earnings ratios to tell the truth about a company is to make sure they reflect normal results, not ideal ones. The price to earnings ratio is only as reliable as the main ingredient, earnings. Here's what to watch to be sure they're on solid ground.
1) Chronic excuse-making. Some companies report "onetime" charges to earnings almost every quarter, knowing that Wall Street tends to ignore such charges when discussing earnings.
2) Looks good on paper, but...When a mature company reports several quarters of excellent earnings but weak free cash flow, it could be a sign that earnings are about to dip.
3) Cliff ahead? An ultralow P/E could be a sign that recent earnings are unsustainable. Make sure shares are priced cheaply enough to compensate for possible problems.
I wish to thank Jack Hough for the information he published in Smart Magazine, and again published here. For more on what information is important when doing research, and how to create profits in the stock market visit http://www.youcontrolinvesting.com/ to get started.
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