Follow the Financial Brick Road

Follow the Financial Brick Road

Investing.

The mere mention of the word sends shivers down the spines of many. But it doesn’t have to be that way.

The more we learn about money and how to make it grow, the less fearful we will be.

So today I want to tackle some of the financial illiteracy we face as a society by sharing my research on two metrics used by financial analysts when determining whether or not a stock is worth their time.

Finding Value Using “Price-Earnings Ratio”

This is one of the most widely used — and often misused — metrics of a stock screen: the price-earnings ratio, or P/E ratio.

Despite its popularity, the P/E ratio is commonly misused because investors often aren’t sure exactly how to interpret this seemingly innocuous number.

The P/E ratio is calculated by taking the share price and dividing it by the earnings per share (EPS).

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A company’s EPS serves as an indicator of its profitability; it is the profit allocated to one share of the company’s stock. EPS can be found by taking a company’s net income and dividing it by the number of outstanding shares. For that reason, the P/E ratio is essentially a measure of how much investors are willing to pay for each dollar of a company’s earnings.

Now that you know how to find the P/E ratio, you need to know how to interpret it. But before we get to that, there are some important details we should note…

When calculating a company’s P/E ratio, earnings are obviously a major factor. It’s important to know, however, that earnings can be subject to manipulation. For instance, a company’s reported earnings can include noncash items like depreciation, amortization and unrealized investment losses — those numbers can be discretionary and they have a direct impact on the ultimate price-earnings results.

The P/E ratio can also vary by industry. When using P/E ratio to compare one company with another, it is important to make sure you are comparing companies within the same industry. You can even go a step further and compare a company’s P/E with the industry’s average.

Because the P/E ratio is subject to these variables, it should be used as a guideline with other metrics. You can’t pinpoint the exact value of a company by this metric alone.

There are many different ways to interpret what a company’s P/E ratio means. A lower P/E ratio can mean that a stock is undervalued, but it can also mean that investors believe the company’s earnings are set to decline. Stocks that have a higher P/E ratio are thought to be overvalued or could see growth in the future.

As you can see, using the metric won’t give you a concrete value of a specific stock, but it is a crucial starting point.

Remember, because of all the variables that can affect P/E ratio, this metric should not be used alone.

Uncover Value Opportunities Using the Price-to-Book Ratio

What if you could buy a company for less than it’s worth? The price-to-book ratio, or P/B ratio, could be just the metric to tell you everything you need to know…

As with the P/E ratio, this metric should never be used by itself; however, it is still an important tool for finding value in investments.

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You can find the P/B ratio by taking the company’s share price and dividing it by the latest book value per share.

Book value is found by subtracting a company’s liabilities from the total value of its assets. Essentially, it’s the value of all a company’s stuff after taking out any obligations. It’s a conservative measure of a stock’s liquidation value per share.

The P/B ratio is often used by investors to find companies selling at deep-value prices. Like the P/E ratio, there are many ways to interpret this metric.

When calculating the P/B ratio, the book value of a company’s assets is a huge factor. That’s why it’s so important to understand what is included within a company’s book value.

Book value is simply the value of a company’s net assets expressed on their balance sheet. This includes a company’s stocks, bonds, inventory, manufacturing equipment and real estate, minus any debt. It gives a rough idea of what the stock would hypothetically be worth if it were broken up and sold off tomorrow.

The most important thing to know is that it excludes intangible assets such as brand name, patents and intellectual property. Companies that rely heavily on intellectual property, like Microsoft (NASDAQ: MSFT), do not always have significant tangible assets on their balance sheet; that can cause the P/B ratio to be higher, which makes the company look like less of a deal.

Also, book value may not represent the real market value of a company’s assets. That’s because the book value of an asset typically reflects the original cost and doesn’t account for value increases in property or for the markup that inventory gets before being sold.

Because of the variables that go into book value (and what is left out), companies in certain industries consistently have higher P/B ratios than those in others. Companies with a lot of tangible assets (machinery, real estate, etc.) will have a lower P/B ratio than companies that rely heavily on human capital.

A higher P/B ratio may mean that investors expect management to create more value from a given set of assets. It can also mean that the company is overvalued. The only way to tell the difference is through tried-and-true experience.

Newer companies with high expectations tend to have higher P/B ratios. When looking at newer companies, it is important to compare the P/B ratio with the industry average. If the P/B ratio is higher than the industry average, it may be wise to stay away.

A lower P/B ratio means that share price is less than the value of assets. Sometimes, this means the company is undervalued, but just like with a low P/E ratio, it can also mean the company is in trouble.

That said, a low P/B ratio can indicate that if the company gets into trouble, investors could still walk away with a profit on their investment. Lower P/B ratio gives investors a fundamental cushion if the company has difficulties.

Just like with P/E ratio, P/B ratio should never be used by itself. But it is an important metric when evaluating a company’s assets. Keep tuning in for more useful ways to figure out whether a company is worth your time.

With purpose,

Patrick Gentempo

Patrick Gentempo