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|> About Money 101

investing 101

  How much should you pay?
The right way to use P/E and other valuation tools.

When times are good, investors think the happy days will last forever, and they are willing to pay exorbitant amounts for earnings. When times are bad, they assume the world is ending and refuse to pay much of anything. In assessing how much a stock is worth, investors talk about "valuation," the stock price relative to any number of criteria. The P/E, for example, compares a company's stock price to its earnings.

Price/earnings (P/E) ratio Everybody uses it, but not everybody understands it. The actual P/E calculation is easy: Just divide the current price per share by earnings per share. (Just about every finance website with a quote box provides the P/E -- including MONEY.COM.) But what number should you use for earnings per share? The sum of the past four quarters? Estimates for next year?

There is no right answer. The P/E based on the past four quarters provides the most accurate reflection of the current valuation, because those earnings have already been booked. But investors are always looking ahead, so most also pay attention to estimates, which also are widely available at financial websites (including MONEY.COM). Wall Street analysts generally compute earnings per share estimates for the current fiscal year and the next fiscal year (though there is no guarantee that the company will meet those estimates).

The P/E can't tell you whether to buy or sell -- it is merely a gauge to tell you whether a stock is overvalued or undervalued. Is a $100 stock more expensive than a $50 stock? Maybe not. IBM, for example, was trading at $110 in February and was expected to earn nearly $5 a share in 2001 -- a P/E of 22. Home Depot, meanwhile, was trading for just $44 -- but it was slated to earn little more than $1 per share in 2001, for a P/E of around 40. So IBM, selling for more than twice the price of Home Depot, is a ctually the cheaper stock (though not, necessarily, the better buy).

What's an appropriate P/E? Different types of stocks win different valuations. Generally, the market pays up for growth. That's one reason Home Depot has a higher P/E than IBM -- its earnings are growing at 23 percent annually, versus just 13 percent for IBM.

To quickly compare P/Es and growth rates, use the PEG ratio -- the P/E (based on estimates for the current year) divided by the long-term growth rate. Home Depot, with a P/E of 40 and a growth rate of 23 percent, has a PEG of 1.7. In general, you want a stock with a PEG that's close to 1.0, which means it is trading in line with its growth rate, but for a quality company, you can pay more.

Also, don't get excited by rock-bottom P/Es -- some companies are doomed to low valuations. One group the markets tend to penalize is cyclicals, companies whose performance rises and falls with the economy. Ford, for example, is arguably the best-run automaker and is highly profitable. But its P/E is just 10 -- and that's considered generous for an automaker.

Price/Sales ratio Just as investors like to know how much they're paying for earnings, it's also useful to know how much they're paying for revenue (the terms "sales" and "revenue" are used interchangeably). To calculate the Price/Sales ratio, divide the stock price by the total sales per share for the past 12 months. (Revenue estimates are not as widespread as earnings estimates.)

Like P/Es, Price/Sales ratios are all over the map, with fast-growers tending to get the highest valuations. Cisco's Price/Sales ratio is more than 8, for example, while Ford's is just 0.3.

Next: Picking stocks

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