FOOLISH FOUR PORTFOLIO

<FOOLISH FOUR PORTFOLIO>

What Is That Stock Worth?
And answers to Tuesday's homework problem

by Ann Coleman (TMF AnnC@aol.com)

Alexandria, VA (February 19, 1999) -- How do you know what a share of stock is really worth?

Over the past three weeks, we have talked about how a "share" is a very flexible concept. And we have talked about how the worth of a company is related to its future earnings flow -- which is, of course, fairly impossible to predict accurately. It seems that deciding what a company or a share of stock is truly worth is impossible. In many respects, it is. If you were expecting an actual answer to the question above, there really isn't one.

That what makes investing such fun. It's "The Price is Right!" for real money. Everyone is guessing about what they think a company is worth; those who guess best win.

One of the most basic measures of a stock's value is the price to earnings ratio, which we defined on Tuesday. It lets you see what you are paying for a stock in terms of the company's current earnings per share. (Please note, a company that is not earning money cannot be evaluated with the P/E -- don't even try. There are other ways. See How to Value Stocks.)

Figuring out what a share of stock is actually worth is at best a game of guesses and approximations, but if you are going to invest in stocks outside of a mechanical strategy like the Foolish Four, it is essential to have some idea of worth, and a good place to start is the P/E.

Let's look at the P/E slightly differently. When you buy a share of stock, you are buying a percentage (albeit a very small one, usually) of the company. Buying a percentage of a company is not that much different from buying the whole company in many ways. So let's look at the price to earnings ratio of a whole company.

Caterpillar, Inc. (NYSE: CAT) is a nice company. If you were really, really rich, you might buy the whole thing as a birthday present for your 4-year-old who has a fascination with earth-moving machinery. What would it cost you to do that?

Well, the company has 359 million shares outstanding, each of which is selling for around $45 -- so if you had $16 billion lying around, give or take a few hundred million, you could buy it outright. That would give you exclusive rights to the company's future earnings. Those earnings could go into your pocket, or be reinvested in the company in hopes of increasing earnings in the future, or some combination of both, but they are yours to dispose of.

Little Pat's delight aside, have you made a good purchase? (You, of course, had a few financial considerations in mind as well your darling's birthday.) Well, CAT earned $1.51 billion dollars in net profits in 1998, and earnings are the key to a stock's value, right?

You spent $16 billion. That means that every dollar of company earnings cost you roughly $11. Now, if you had only bought part of the company (say, one share), you would have spent around $45. The company's earnings per share (total net profit dividend by the number of shares outstanding) was $4.10. You own those earnings even though, as a shareholder, you have to abide by the majority's decision about whether to reinvest the earnings or pocket some or all of them.

What's your P/E? 45/4.1 = 10.97, call it 11. In either case, a dollar of earnings costs the buyer $11.

Now what is that P/E of 11 good for? Remember, it's unit pricing for stocks, so you can compare the price of CAT's earnings with those of other companies. John Deere (NYSE: DE), for example, is selling for a P/E of around 8. Oh. Maybe Pat would have liked the Deere better than the CAT logo. (What is it with earth moving equipment and cute mammals?)

Well, let's look at how CAT's P/E compares with something in another industry, say, computers. Wow. Microsoft (Nasdaq: MSFT) has a P/E of 67! Obviously, something else is going on here. But that's for Monday's report.

Meanwhile, here are the answers to Tuesday's homework assignment, which, you will remember, was to calculate the P/E for our Foolish Four Portfolio stocks based on the price as of the close of business that day.

Prices (From Tuesday's Foolish Four Portfolio Report)
Caterpillar (CAT) $ 45.25
J.P. Morgan (JPM) $110.25
3M (MMM) $ 76.44
International Paper (IP) $ 41.94

Earnings (from quote.fool.com)
CAT $4.10
JPM $4.68
MMM $2.97
IP $0.70

P/Es
CAT    45.25/4.10  = 11.03 = 11
JPM   110.25/4.68  = 23.56 = 24
MMM    76.44/2.97  = 25.74 = 26
IP     41.94/.70   = 59.91 = 60

Did you get the right answers?

One way to check yourself is to use the detailed quote screen at quote.fool.com. When I did that I turned up an interesting anomaly, though. While the P/Es have shifted a bit due to prices moving around over the last day or two, the P/E for J.P. Morgan is wildly different from what we have. Our quote server (hey, we just buy this data, we don't make it!) seems to be using last year's earnings for JPM. Ooops, somebody forgot to update.

While I would have preferred not to have such a graphic example at our expense, this is not an uncommon thing. Numbers are numbers, but somewhere along the line a human being has to input them, and errors will creep in. Always check your numbers and your sources. In this case, our Snapshot has the right number, and since it agrees with the earnings and price numbers, we will take it. But, just to be sure, I checked at the J.P. Morgan website. Interestingly, they are showing earnings of $4.71 per share. (The discrepancy is probably due to multiple rounding errors over several quarters. A discrepancy of less than 1% isn't worth worrying about.)

Hey, aren't mechanical strategies like the Foolish Four, which requires nothing like this kind of research, looking better and better?

Fool on and prosper!

Make a Living Foolin' Around.

 Recent Foolish Four Portfolio Headlines
  12/28/00  Modifying Mechanical Strategies
  12/27/00  Beating the S&P Year 2000 Recap
  12/26/00  After-Hours Quotes
  12/22/00  Why Include the Foolish 4 Port?
  12/21/00  The Value of Community Input
Foolish Four Portfolio Archives »  

Today's Stock Lists | 1998 Dow Returns

02/19/99 Close
Stock  Change   Last
--------------------
CAT  +   1/4   45.06
JPM  -1        110.63
MMM  +   7/16  76.75
IP   +   3/8   42.06
                   Day   Month    Year   History
        FOOL-4   +0.28%   3.29%   1.13%   2.63%
        DJIA     +0.44%  -0.20%   1.87%   1.47%
        S&P 500  +0.15%  -3.16%   1.13%   1.37%
        NASDAQ   +1.01%  -8.88%   4.14%   5.57%

    Rec'd   #  Security     In At       Now    Change

 12/24/98    9 JP Morgan    105.51    110.63     4.85%
 12/24/98   24 Caterpillar   43.08     45.06     4.60%
 12/24/98   14 3M            73.57     76.75     4.32%
 12/24/98   22 Int'l Paper   43.55     42.06    -3.42%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1081.50    $47.50
 12/24/98    9 JP Morgan    949.62    995.63    $46.01
 12/24/98   14 3M          1030.00   1074.50    $44.50
 12/24/98   22 Int'l Paper  958.12    925.38   -$32.75


                             Cash     $28.26
                            TOTAL   $4105.26

</FOOLISH FOUR PORTFOLIO>