Finding the right P/E ratio
Should you use past earnings or future to measure a stock's value? The answer guy sets a reader straight.
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(Money Magazine) -- Question: I use price/earnings ratios to decide if a stock is a good value. But they always seem to be based on a firm's predicted future earnings. Wouldn't it be more reliable to use actual past earnings? - Ryan North, Kenmore, Wash.
Answer: Sometimes a guess about the future is better than rock-solid knowledge of the past.
The P/E ratio - the price of a stock divided by the company's annual profits per share - is a yardstick used by almost all investors to value equities. It tells you how much you're paying for each dollar of earnings. The lower the P/E, the cheaper the stock, generally speaking.
While P/Es based on forecast earnings (also called forward P/Es) are common, they're not always the numbers kicked around; CNNMoney.com uses past earnings. Others rely on "current year" estimates, which are a mix of actual and projected profits for a given year.
Which is most useful? It depends. Wendell Perkins of Optique Capital Management says that if you're valuing an economically sensitive business, you need to look forward, since a company's profit picture can change quickly. Case in point: the home builders. Sure, there's a risk: Analysts are often wrong. But looking backward can be equally dangerous, since it's akin to rearview investing.
Along with trying to figure out which P/E is best, make sure you know which measure - future, trailing or current year - you're dealing with. Then, when valuing one stock vs. another, be careful to compare apples with apples.
Question: I have a 457(b) deferred-compensation plan with my employer, a nonprofit. My understanding is that if my company files for bankruptcy, I could lose the money I've put in. Should I keep contributing? - Edward Yee, Orlando
Answer: You're right - you could lose your money if your employer goes bankrupt. But this worst-case scenario is a rare one.
Let's review the basics: Like a 403(b), a 457(b) is a tax-advantaged retirement plan offered by some nonprofits and state and local governments. Yet unlike with a 403(b) or for that matter a 401(k) - where assets belong to the workers - money held in a 457(b) is the employer's until the funds are paid out (in some cases the assets are held in trust, though that's not always the case).
The 457(b) assets of government workers are protected - no one else can get at them. But for nonprofit employees, it's possible that the money could be seized by creditors if the employer files for bankruptcy protection.
Thus 457(b) plans may pose a risk akin to the one that recently burned Bear Stearns employees with too much savings tied up in company stock: You could lose your job and your retirement savings.
Still, it's hard to say that nonprofit workers should be terribly worried. Bankruptcies are much less frequent among nonprofits. And even in a bankruptcy, creditors might not be able to get their hands on your funds. Experts were stumped when Answer Guy asked for examples of 457(b) plans gone bad.
"I'd be surprised if there have been large numbers of losses in these plans," says D.C. attorney David Powell. You have a better idea of your employer's health than Answer Guy does, but it seems like a small risk.
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