Fool.com: The Fool Ratio Explained [The Fool Ratio]http://www.fool.com/school/thefoolratioexplained.htm
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:
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,