FOOLISH FOUR PORTFOLIO

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Why Stock Rise, Part 4
How much are investors willing to pay?

by Ann Coleman (TMF AnnC@aol.com)

Alexandria, VA (January 29, 1999) -- When you buy a share of stock, what are you buying? I hope that on Wednesday we established that you are buying into the earning power of the company -- the company's ability to generate cash that will be shared with you in the form of dividends (now or later) or reinvested in the company to increase its intrinsic value and future earnings-generating ability.

How much investors are willing to pay for that earnings capacity determines the price of a share of stock.

On Monday I mentioned in passing that earnings were the "bottom line." What was I thinking, using such a tired, old cliche?

One of the financial statements every public company must file with the SEC is the Income Statement. The Income Statement starts off at the top with the company's gross revenue -- total money received -- and then proceeds to the subtracting. Out comes the cost of goods sold, administrative expenses, the new corporate jet that the CEO couldn't live without, interest on loans, Uncle Sam's share, preferred stockholders' dividends, etc., etc. Finally, you get down to profits, or net earnings.

Net earnings don't tell the whole story, though. Suppose Coffee Shop on Every Corner, Inc. (Nasdaq: CUPA) has net earnings of a two million dollars and General Consolidated Conglomerate (NYSE: BIG) has net earnings of one billion dollars. Obviously, big companies should make more money than little ones, but which is better? CUPA has one million shares, owned by individuals, mutual funds and other corporations, so each share's share of the earnings is two dollars. BIG has one billion shares outstanding, so each share's share of those earnings is just one dollar.

Right at the bottom of the Income Statement, the company's net earnings are divided by the number of shares outstanding. The result is EPS -- earnings per share. Literally, The Bottom Line.

That figure is so important in valuing a company that its position on the Income Statement has passed into common usage to denote the ultimate reality, the essential fact. It has become a cliche. A very apt one, in this case.

A stock's price is determined by how much investors are willing to pay for that ultimate reality. That's where the all important PE comes in. The PE is the Price/Earnings Ratio. Actually, it's P/EPS. To get a company's PE, you divide the price by the earnings per share. A company that is selling for $50.00 and has earnings of $2.00 per share has a PE of 25. A company with earnings of $1.00 per share that is selling for $25.00 has exactly the same PE: 25. In very real terms, those companies are selling for the same "price."

It's easy to think of a PE as the result of the share price, but it might be more helpful to think of it as a cause -- or even a price tag. In effect, the market (the aggregate votes of all investors) is saying that a dollar of this company's earnings is worth x dollars. The PE levels the playing field, letting investors compare the price of a small company with a big one or a computer company with a grocery store.

Of course, it's never that simple. Even though the quoted PE is based on the most recent year's earnings, the market actually bases the company's share price on its anticipated earnings. That's why pricing is so messy, and that's how companies with no earnings can have share prices. Someone, at least, thinks that eventually the company will have earnings.

Remember that if enough people think a stock will go to $50.00 tomorrow, it will go to $50.00 today. So if a company has an established price tag (PE) of, say, $20.00 per dollar of earnings, and the market thinks earnings are going to double, then the price will double. Here's how that works:

Anticipated earnings = $2.00 P/E = 20 Price = $40.00

Earnings for next year are revised and projected to be $4.

Anticipated earnings = $4.00 P/E = 20 Price = $80.00

In a case like this, though, if the new earnings growth rate appears sustainable, the market may decide that $1.00 of current earnings is worth more than $20.00 because those earnings are fueling growth at a higher rate.

Here's an example of how a higher growth rate effects earnings. Company A is growing at 20% per year. Company B is growing at 40% per year. If the market's price tag (PE) is assumed to stay at a constant 20 for both companies, here's how the price grows:

          Company A  Company B
PE                20        20
EPS-Year 1     $1.00     $1.00
Price year 1  $20.00    $20.00

EPS-Year 2     $1.20     $1.40
Price year 2  $24.00    $28.00

EPS-Year 3     $1.44     $1.96
Price year 3  $28.80    $39.20

EPS-Year  4    $1.73     $2.74
Price year 4  $34.60    $54.88

EPS-Year 5     $2.07     $3.84
Price year 5  $41.47    $76.72

The factors that determine the PE are many and varied, but usually rational -- at least in the long run. In the case above, it is quite likely that the market would decide that the company was worth more than $2.00 per dollar of earnings. Which company looks like the better deal to you? Which one would you pay more for right now, if you believed the growth rate projections?

Monday: More about earnings and PEs. (It's an inexhaustible subject. I'll try not to exhaust everyone too much!)

Fool on and prosper!

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Today's Stock Lists | 1998 Dow Returns

01/29/99 Close
Stock  Change   Last
--------------------
CAT  -1  3/16  43.31
JPM  +1  1/8   105.50
MMM  +2        77.63
IP   -   1/2   39.56
                   Day   Month    Year   History
        FOOL-4   -0.03%  -2.10%  -2.10%  -0.64%
        DJIA     +0.84%   1.93%   1.93%   1.53%
        S&P 500  +1.10%   4.07%   4.07%   4.32%
        NASDAQ   +1.15%  14.28%  14.28%  15.85%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   14 3M            73.57     77.63     5.51%
 12/24/98   24 Caterpillar   43.08     43.31     0.54%
 12/24/98    9 JP Morgan    105.51    105.50    -0.01%
 12/24/98   22 Int'l Paper   43.55     39.56    -9.16%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   14 3M          1030.00   1086.75    $56.75
 12/24/98   24 Caterpillar 1034.00   1039.50     $5.50
 12/24/98    9 JP Morgan    949.62    949.50    -$0.12
 12/24/98   22 Int'l Paper  958.12    870.38   -$87.75


                             Cash     $28.26
                            TOTAL   $3974.39

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