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is a PE Ratio
P/E Ratio is one part of what's known as Fundamental Analysis,
which is a set of tools used to evaluate the health of a
company and the value of its present and future assets relative
to the stock price. The P/E Ratio is calculated by taking
the price per share and dividing it by company's earnings
per share. Thinking logically, you might assume that lots
and lots of earnings and a low stock price, which translate
into a low P/E ratio, would always make for a bargain. There
are people who will tell you that, but it's not always the
case. You're better off taking a relative look at the P/E
ratio, looking at the current P/E and comparing it to what
the company has done in the past. Also, comparing a company's
P/E ratio to industry averages is a good idea.
Take a look at this good reference on Fundamental Analysis.
The P/E is good, but it's really just the beginning.
Beta is a different animal altogether. It falls under the
umbrella of Technical Analysis, which is a more advanced
trading technique. Without getting into too elaborate an
explanation, Beta is a measure of a stock's volatility relative
to the market as a whole. In other words, it's a way of quantifying
how deep the peaks and valleys are on a stock's chart, and
how often they come. That information is useful mostly to
day traders, who make their trades minute to minute and hour
Dissecting the Income Statement
By Andrew Greta
Special to TheStreet.com
While the balance sheet is like a snapshot of a company's
financial structure at a specific point in time, the income
statement is more like a motion picture showing the firm's
operating activities for an entire year.
The balance sheet can show how financially sound a company
is. The income statement can answer every investor's central
question: "How much money are they making?" Even
more important, the income statement can provide a solid
basis for forecasting future profits.
Here, more than anywhere, one-year figures are all but worthless
in predicting future performance. Since most income statements
include three years of information, it's best to download
at least two from freeedgar.com or your favorite info source.
For my examples, I imported the 10-Ks from Anheuser-Busch
(BUD:NYSE - news) from 1997 and 1994 directly into my Excel
spreadsheet to get a full six years of data in an easily
Understanding the layout of an income statement is a fairly intuitive
process. After starting at the top with "sales" or "gross
revenue" (whatever the main source of income is for the firm),
the company subtracts out itemized expenses to get to a final net income
(or loss) for the year. Think of it like getting your paycheck and
then deducting taxes, rent, living expenses and insurance. The amount
left over is your discretionary income or profit for the month.
One big difference between you and the firm (other than
that they deal in millions rather than thousands) is that
the term "income" doesn't necessarily refer to
cash in hand. The accrual rules of accounting state that
a firm can record income when it sells goods or services
regardless of when payment is actually received. In addition,
expenses are recorded at the time the purchased asset is
If, for example, a firm bought a five-year insurance policy
at the beginning of 1998 for $10,000, it would record only
$2,000 per year as an insurance expense until the policy
expires, instead of expensing the entire 10 grand up front.
It's kind of a technical distinction but an important one,
since a company with positive earnings on the income statement
can still go bankrupt if it doesn't have enough cash on hand
to meet day-to-day needs. That's why checking the balance
sheet for sufficient working capital through the "current
asset" ratio as described in part two is so critical.
the firm checks out for reasonable financial soundness
(again, see the prior discussion of the balance sheet),
turn your attention to the bottom line of the sheet called "earnings
per share" to see how the company stacks up over several
years of performance. This figure represents the total
net income divided by the number of shares the firm has
issued. Think of it as your share of the corporation's
overall profit if it paid everything out to the stockholders
and kept nothing to reinvest in the business. If the earnings
are declining over time or jump around unpredictably, then
you may want to bag your analysis and pick another stock.
While there may be money to be made trading some of these
issues in the short run, the fundamentalist is looking
for steady, long-term earnings growth -- even better if
it seems to accelerate over time. You might even want to
plot the percentage growth on your spreadsheet to get an
idea of just how fast the firm is growing.
For BUD, the earnings history seems a little erratic in
recent years, especially for a producer of consumer staples
like beer. The company even had a bit of a stumble in 1995,
so I went back an additional six years to get a longer view.
While the earnings picture that emerged seemed pretty stable,
sloping higher at around 11% per year, the pace of growth
also appears to be tapering off a bit. I'll call the whole
thing a yellow flag for now.
The profit margin is simply the net income divided by the
gross revenues (or sales). The resulting figure (see blue
line in graph below) shows the percentage of each dollar
received that made it to the bottom line as profit for the
1997, BUD kept 10.6 cents of every dollar it received as
profit. (Because of an excise tax in the income statement,
I used net sales in this case. You can also do the calculation
excluding one-time charges from net income. That's the green
line in the graph.) In and of itself, this profit margin
number is pretty much meaningless.
Compared to its rival Coors (ACCOB:Nasdaq - news), which
sports a scant 3.8% profit margin, however, this profit margin
starts to look pretty good. You can also compare Anheuser's
profit margin with the entire brewing industry on services
like RapidResearch , which shows BUD sporting margins 40%
higher than the industry average.
Even more telling is how margins change over a period of, say, five to
six years. Plugging a quick formula into your spreadsheet (net income
divided by gross revenues), you see that that BUD has steadily grown
its profit margin from around 8.5% in the early '90s.
This means that Anheuser-Busch is making more money on
every mug of suds sold to the parched public. Coupled
with sales increases ringing in at nearly $13 billion
for the year, those pennies really add up. What we don't
want to see is a firm with steadily declining margins.
There are two ways a company can grow earnings over time.
It can either increase revenues or cut costs. BUD seems to
be handling itself well on both fronts and gets high marks
for overall profitability.
Interest Coverage Ratio
Few things will panic investors more than a company that's
unable to make its interest payments. While (most) stockholders
are in for the long run and can weather the occasional bad
quarter, bond investors demand their payoff every year like
clockwork and are notoriously unforgiving if those checks
stop rolling in. The next examination of the income statement
is to make sure the firm can meet the demands of its creditors
even during a temporary downturn.
The interest coverage ratio takes the earnings before interest
and taxes, or EBIT and divides it by the interest expense
to figure out how many times over the interest payments could
be met with current income. Since EBIT isn't always itemized
on the income statement, you need to do some simple figuring.
Think of the process like trying to find out the maximum
number of home mortgage payments you could make with your
current level of income. The first step is to find your taxable
income for the period, which in a corporation's case is titled
intuitively enough "pretax income." You might be
tempted to just divide this number by your current debt payment
to get your "mortgage coverage ratio." But wait!
Since the government allows you to deduct this expense from
your taxable income, the pretax income figure already has
your current interest payments taken out. Since the question
is "how many houses can I afford in total" and
not "how many more houses can I afford," you need
to add back the current interest expense to your pretax income
before doing the final calculation.
For BUD in 1997, the formula looks like this (figures in
$1,832.5 (pretax income) + 261.2 (interest expense)
261.2 (interest expense)
In other words, BUD has eight times as much income as it
needs to make its required interest payments. Analysts recommend
that firms be able to cover their interest charges at least
three to four times over, so BUD is in great shape here.
Akin to the earnings per share is the price-to-earnings
ratio, or P/E. It's calculated simply by dividing the market
price of the stock by its current EPS to give an earnings "multiple." The
figure is a way of comparing prices of stocks on a relative
basis. A $100 stock trading at a P/E of 8 is "cheaper" than
a $20 stock with a 30 P/E.
Some folks think that low-P/E stocks are always better then high-P/E
issues. Unfortunately, there are no absolutes. High-growth stocks usually
deserve a higher multiple than their stodgier brethren because of higher
expectations for future performance. Conversely, some value investors
would argue that these high-P/E stocks have further to fall if their
earnings ultimately disappoint, because those same inflated expectations
are fully priced into the stock.
Low P/E stocks seem to offer a type of safety net since
the market isn't expecting much from them in the first place.
The risk here is that these bottom-feeders might hang around
their current trading levels for years and never make a substantial
move to the upside.
Our calculation of P/E relies on "trailing" earnings
-- the real earnings in the past rather than future expectations.
Some analysts like to make an earnings forecast and then
quote the stock on a "forward P/E" basis. A stock,
for example, with a current multiple of 50 that is expected
to double its EPS next year would trade at a forward P/E
of only 25. Admittedly, forward P/Es might be a better way
to view the whole value proposition, but problems arise in
determining whose forecast is reliable enough to use.
That said, using current or trailing P/E to measure relative
value is fine. Just keep it in perspective. A stock trading
way above its historical multiple or well above the industry
P/E and broader S&P multiple had better be up there for
a good reason (something like a hot new product, dramatically
improved productivity or promising new alliance). Conversely,
a stock with a low P/E might not be a screaming bargain if
the company is having internal problems.
But assuming the stock clears the other fundamental hurdles
as described here, a relatively low-P/E stock compared to
its own history or industry average might just be the perfect
value you've been waiting for. At the end of '97 BUD was
trading at 18.6 times earnings, which was about average for
A basic approach to dissecting the income statement might
go something like this:
- EPS Growth: Earnings that are steadily increasing over
time at a respectable rate get passing grades; otherwise,
think hard about the long-term prospects of such a firm.
- Profit Margin: Steadily increasing profit margins get
the thumbs up; declining margins are the sign of a struggling
- Interest Coverage Ratio: A figure of 3 to 4 is the bare
minimum. Anything higher and you're in good shape.
- P/E Ratio: No absolutes here. A low one relative to
the industry or historical averages is the sign of a good
value, assuming other areas check out.