How to Value Stocks: The Fool Ratio

The Growth Rate Examined

How to Value Stocks

Many investors make the mistake of viewing the P/E ratio alone, in a vacuum, as if the numbers 17, or 5, or 43 could serve as effective valuation tools on their own. You'll occasionally hear such an investor say something like, "I don't buy stocks with P/E's over 30." To our Foolish ear, that sounds identical to, "I don't buy hydrogenated milk; I am born in May." In other words, it's contextless random drivel.

Another person, wise fellow, will state emphatically, "Will you look at that P/E of 75?! The stock is OUTRAGEOUSLY overvalued!" To our Foolish ear, that's kind of like saying, "Look at the thermometer; the temperature is 75!" But unless we know what season it is, and what are the average outdoor temperatures during that season, we have nothing to relate the comments to. . . they are non sequiturs.

P/E's need to be placed in a context that gives them meaning. And here's where the aforementioned rule of thumb comes in handy: "In a fully and fairly valued situation, a growth stock's price-to-earnings ratio should equal the percentage of the growth rate of its company's earnings per share."

Imagine this scenario. Your mother, who always did love a good hamburger, wants you to put some of her money at play in the fields of fast-food. As you've been entrusted with the responsibility of picking stocks for her retirement account, you'll have to do some prospecting. Your efforts unearth these two:

Best By Far Burgers Int'l:   
Price $40, EPS $1.00, P/E 40

Your Typical Burger Corp.: 
Price $20, EPS $1.00, P/E 20

OK, now which would you pick?

Your Typical Burger, right? After all, both companies have generated the same earnings per share (EPS), meaning that the same amount of profit per share backs each stock. One is trading at half the price of the other. Certainly you should buy the lower-priced.

GONG! (A wavering, dissonant gong.)

Unfortunately, that answer is not Foolish enough. We hope you didn't get suckered by our spurious reasoning above; we're patting you on the back if you didn't. But even if you did, don't sweat it. You ain't done the 13 Steps to Investing Foolishly yet, so you're not expected to have all this down-pat. OK, OK, we know. . . as you're a newbie, we need to build up your self-esteem. So OK already, you're still a fine person. . . an asset to our society.

Now, if you did fall on the wrong side of the law in that last one, let's look at your mistake. Simply put, you erred in accepting a P/E valuation without hearing anything about the two companies' growth rates! Investing involves more than a sound knowledge of a company's past and good analysis of its present. What awaits us in the future far exceeds the importance of both combined. In this context, the future means a company's expected rate of growth.

So perhaps Best By Far Burgers is expanding into California, with loads of cash to do so, and an excellent management in place, while the "apparently cheaper" Your Typical Burger is having trouble competing in every one of its markets and has no growth projected for it over the next 3 years. No wonder, then, that even though both companies have the same $1.00 of earnings per share, one stock is trading at twice the price (and therefore P/E) of the other.

All of that is to say that the P/E generally reflects the market's expectations for the growth of a given company (or industry. . . because you can in fact do P/E ratios for whole industries). It takes a Fool to trust in the notion that, "In a fully and fairly valued situation, a growth stock's price-to-earnings ratio should equal the percentage of the growth rate of its company's earnings per share." And it takes an even greater Fool, perhaps, to assert that we can therefore come to value stocks as having traded up or down in different degrees toward that full, fair value.

The growth rate is the subjective piece of the pie. The P/E ratio is hard fact, reported everywhere. Thus, what'll eventually force you to use your noggin in this scenario is the analysis of a company's growth.

Time to learn how to calculate growth rates.

Next: Calculating the Growth Rate »