The Fool Ratio Explained
How to Value Stocks
The Fool Ratio brings together what we've already learned into a new, simple, and terribly meaningful configuration. It numerically expresses the relationship between a stock's current price-to-earnings multiple and the rate of the company's growth.
Let's take the show to Maui, home of the waves, the babes, and get-rich-on-real-estate infomercials.
Maui Joe's Luau Supplies (NASDAQ: HULA) is a tiny niche company with a highflying stock that over the past 6 months has tripled to its current level of $9 per share. Having called the company and obtained the only up-to-date report by any analyst (which took a fingernail-extracting three weeks to arrive in the mail), you first learn that Maui Joe's EPS over the past 12 months has been $0.50. Which makes the P/E ratio 18. You furthermore discover that the analyst projects Maui Joe's to have earned 75 cents per share a year from now. And $1.15 the year after.
Well, we already have the P/E. We need the growth rate. "Calculator on," you vocalize, powering up your trusty sidekick. Lightning fast, you repeat the steps you learned above, coming up with 52% (rounded) for your 2-year annualized growth rate.
"What's the Fool on the stock?" your neighbor across the street has asked you, fondly referring familiarly to our Ratio.
Shouldn't be too difficult to figure out. You have the P/E. You have the growth rate. Now just find the ratio of the P/E to the percentage rate of growth. (18 divided by 52 equals 0.35.) So 0.35 is the Fool on this stock. Trading therefore at just 35% of its full, fair, Foolish value, Maui Joe's might make you some money, as you'll see below.
Like most numbers, the Fool Ratio needs a context before it can take on meaning. That's what we're here for. Here's the context in tabular form:
Fool Ratio Tend To
.50 or less Buy
.50 to .65 Look to buy
.65 to 1.00 Watch (or "hold")
1.00 to 1.30 Look to sell
1.30 to 1.70 Consider shorting
Over 1.70 Short
In plain English, these numbers say, "Tend to buy stocks when their P/E's are half their growth rates; tend to sell stocks when their P/E's equal their growth rates; tend to sell short stocks (cf. "Shorting Stocks," the Eleventh Step to Investing Foolishly in the Fool's School) when their P/E's exceed their growth rates by 30% or more." (We actually prefer to find our shorts among stocks with Fool Ratios of 1.70 or more. That makes us feel REALLY good about the investment.)
The Fool Ratio is our favorite tool, and not just because we came up with it. We think it's darned useful, giving many investors a much-needed guide to the best prices to buy and sell stocks in which they're interested. The Ratio often imposes a trading discipline that is sorely lacking in many of us (the authors included). It can be terribly hard to ignore buying a favorite stock of yours whose Fool Ratio is 0.60. It can be terribly uplifting (and profitable) when, a week later, a short-term decline in this stock brings its Fool below 0.50. Pouncing, you snap up the stock more than 15% below what you would have paid for it, increasing your profit potential that much more.
Of course, the Phillips head screwdriver is another favorite tool of ours, but we don't try to screw lightbulbs in with it. Every tool has its limits. You should regard The Fool Ratio levels included in the table above as a guide only. A useful guide, we believe, but still just a guide. We don't want some guy from Philly to calculate (or possibly miscalculate) a Fool Ratio of 0.47 on a stock he follows, buy it at $12, watch it go to $2, and tell us our approach stinks. Manifold reasons exist for stocks to drop from $12 to $2. Maybe earnings estimates were downgraded, or the company reported a surprise loss, or the market crashed, or whatever. There's a lot more to security analysis than merely calculating Fool Ratios -- learning how to obtain and understand financial statements is also essential. The Ninth Step to Investing Foolishly and How to Value Stocks sections do a good job of this.
Also, please note that the Fool Ratio should not be applied to every situation. We ignore the Fool Ratio (and generally these stocks as well) for the following industries: airlines, banks, brokerage houses, leasing companies, mortgage companies, oil drillers, and real-estate companies. (The list may not be complete, since new industries spring up from time to time, but it's our best shot.)
These industries, for their different reasons, have low P/E's that virtually never reach their growth rates, mainly because their companies are valued off assets they hold (like oil deposits and real estate) rather than operating earnings. The Fool Ratio also has nothing to say about companies with negative earnings, since no P/E exists and determining growth rates (if any) often involves too much guesswork. And finally, the larger the company, the less we rely on the Fool Ratio to guide us. That's because, again, the bigger a company is, the less likely it is to be valued purely off of earnings.
In closing, the greatest beauty of the Fool Ratio is its ability to confer to the average investor a sense of at what price a given stock is a good buy and at what price a good sell. We view this as profoundly important, since the Ratio can ultimately help guide its fans into both long and short positions, seeking to profit up and down at the same time with different stocks.
Now THAT, as those who know our Fool Portfolio will acknowledge, is Foolish.