ALEXANDRIA, VA (Feb. 4, 1998) -- Evening, Fools.
Every Wednesday here in our little world, we'll cover questions asked by Fools on our message boards. Before digging into that, though, a few notes:
a. Our fourth buy report will be released tomorrow;
But now, on to a recent question emailed to me in the wake of the Microsoft buy announcement.
1. The Value, Not the Price
A Fool asks:
This Fool brings up an important issue, particularly for beginning investors. Some conventional Wisdom needs to be debunked here! As ludicrous as it may sound, the price of a company's stock (in and of itself) is largely meaningless. I say "largely" because for investors it does tell us how much we'll pay for each share of ownership as well as how many shares we'll own if we invest X-hundred or X-thousand dollars.
But the number of shares you own fundamentally doesn't matter one way or t'other. What does is the total value of your investment and the total value of the company in which you've invested. As incongruous as it may seem, a $50 stock is not necessarily "less expensive" than a $100 stock. If the $50 stock is Spice Girls Inc. and the company has 5 million shares outstanding, the overall business is being valued at $250 million ($50 per share x 5 million shares = $250 million). Conversely, look at Spice Boys Inc., at $100 per share with 2 million shares outstanding; its business is valued at $200 million. So which of these stocks is more expensive -- the one with a higher share price or the one with a greater total value?
Stock Shares Total Price Out. Value Spice Girls Inc. $50 5 mil. $250 mil. Spice Boys Inc. $100 2 mil. $200 mil.
So, can we all now see that the "expensiveness" or lack thereof of a stock is best reflected in the total value (or market capitalization) of the company, not in its share price. For this reason, from a numerical standpoint, stock splits are meaningless as well (their psychological effect is open for debate). What ultimately matters is how much money you've invested in a stock, not how many shares you own. Swerving all the way back to that initial question, with Microsoft at $150 per share, you could afford nearly 10 shares of Microsoft with your $1500. If you worked through a discount broker charging a $10 fee, you'd pay a 0.7% commission (we like to keep it below 2% here, so that's great). Whether or not you choose to buy Microsoft, what you'll want to focus on when analyzing stocks is the total value of the business as well as the total dollar value of your investment.
2. To P/E or not to P/E?
Web user JStick queries:
JStick, an excellent question. Absurd as it may sound, I'm going to say that both are right -- applied in different situations.
The P/E-to-Growth Ratio (FOOL or PEG Ratio) that you cite is designed to help investors get a loose fair price on companies with less than $1 billion in sales. I say "loose fair price" because as powerful as The Fool Ratio is as a tool, it has some clear limitations -- after all, what model doesn't? The Fool Ratio is used to value smaller-capitalization growth stocks and the ratio relates the present value of the stock to the growth rate of the company's earnings. Essentially, The Fool Ratio holds that, over extended periods of time, a company's share price will grow at a similar rate to its earnings.
Now, for larger companies (in excess of $1 billion in sales), I think that the relationship of P/E to the short-term growth rate becomes less meaningful. Why? Because the market begins to view the growth of these giants as more staid and more predictable. With great companies that churn out consistent sales & earnings growth, year after year, the investing community begins to discount forward earnings. Essentially, they're saying, "If this company grows by 14% per year, and I'm almost certain that they'll hit those growth numbers for five years, that makes for 92.5% total earnings growth over five years. If I want to secure a double in price over the next five years, I'll be willing to pay up 46.25x earnings today, or 1/2 the total earnings growth rate over the five-year period."
Did that make sense? They'll pay for a multiple off earnings that equals half the total growth of the five-year period. And by holding on for that period, they'll reduce the often great expense of regular trading and annual capital-gains taxes.
Now in the Cash-King portfolio, because we're planning to hold these stocks for 10-20 years or longer, we're willing to discount much farther forward. We're suggesting that if a company can grow earnings at a rate of 15% per year, because the total growth over a ten-year period will be 305%, we're willing to pay more than that 15x earnings to secure tax-deferred, ten-year, market-beating growth. This is why we don't require that our large, healthy, well-managed consumer businesses trade at a multiple equal to their annualized growth rate.
Finally, and importantly, the Fool Ratio is valuable. . . but remember that the price-to-earnings ratio doesn't account for the merits or the purity of the "E", or earnings. After all, if those earnings are the result of heavy long-term borrowing, are they as valuable as earnings growth without debt financing? Or if those earnings come from a company carrying very high accounts receivable (a company that has announced sales and earnings that it hasn't yet collected on), are they as valuable as earnings that have been collected upfront?
The P/E ratio and the relationship between the P/E and the earnings-growth rate are very valuable markers en route to your valuation of a stock and business. But remember that they don't reflect the underlying, more permanent strength of operations in the way that the balance sheet does. Given that the Cash-King model proposes buying for a very long period of time, we want to buy that more permanent operational strength -- and so we are more focused on the balance sheet. That's why we've introduced the Foolish Flow Ratio, to assess the balance sheet, and that's why we rely on it.
To close with a short mnemonic that I can explain in greater detail in the Cash-King folder: The shorter your time horizon, the more you should rely on earnings-growth valuation tools like the Fool Ratio. The longer your time horizon, the more you should rely on your assessments of the balance sheet and the durability of the business.
Hope that helps. See you all in the message folders. And another buy report lands here tomorrow.
Tom Gardner (TomG@fool.com)