Stock Valuation Overview for a Fund Certificate
This article is part of the Advisory Investing Series, which
can be very useful for those pursuing a fund certificate, or
taking annuity courses. A fund certificate covers many areas
of finance, but mutual funds are a key component in this
type of program. A fund certificate should cover other areas
(such as including annuity courses) so that you have a
well-rounded knowledge of the finance sector.
Mutual Funds: Stock Valuation
Ultimately, people buy stocks to own a piece of a
corporation's earnings. If the XYZ Widget Company earns $5 a
share and its stock sells for $100 a share, it has a P/E
ratio of 20; an investor is paying $20 for every $1 of
earnings. As a broad generality, a company in a seasoned
industry group selling at a 30 P/E is said to be expensive;
one selling at a 10 P/E is said to be cheap. The market
meltdown of 2008 and 2009 may or may not alter these
historical numerical guidelines.
Unfortunately, company earnings are not particularly stable.
It is easy for corporate accountants to "fiddle" with
reported earnings to the point where they are almost
meaningless. For these reasons, P/E has only limited value.
Corporate earnings provide useful information only when
averaged over several years. Publicly traded companies have
two P/E ratios: "trailing" and "estimated." The trailing P/E
is most commonly used and represents a corporation's actual
earnings over the past 12 months; estimated earnings are a
forecast for 12 months in the future. Unless otherwise
noted, all P/E figures shown are trailing.
Over the past 80 years, the stock market's P/E ratio has
ranged from a negative number (the Great Depression) to over
45 (early 2002). By historical standards, when the market's
P/E is about 7, it is definitely cheap; when it is greater
than 20, it is expensive. As of late June 2010, the Dow's
trailing P/E was 15.2.
The P/E ratio shows how long it would take to earn back
(through current earnings) the price paid to acquire 100% of
a company. For example, On March 9th, 2009, a company, let's
call it XYZ company, had a P/E of eight. If someone bought
100% of all XYZ stock (thereby becoming the sole owner), it
would take just eight years for the investor to recover 100%
of the purchase price-based on XYZ's current earnings (no
projection for increased earnings, which would lower the
number of years).
Phrased another way, it would be impossible to duplicate
XYZ's presence, market share, reputation, product line and
research in eight years (note: it would be highly unlikely
such a feat could be done in 20 years-meaning XYZ stock is a
bargain based on its current P/E ratio). A number of
blue-chip companies in 2008 and 2009 reported negative
earnings-no earnings or a loss means a non-existent or
negative P/E ratio.
A company may not have any earnings but all companies have a
book value. This indicator can be thought of as the net value
of a company's total assets. A stock with a P/B of less than
1 is said to be cheap; one with a P/B of more than 5 is
expensive, at least relative to its book value. The book
value of a stock is considered to be very stable.
The price-to-book value ratio (P/B) represents the recent
closing stock price divided by the theoretical dollar amount
per common share one might expect to receive from a company's
tangible book assets should liquidation take place. Some
studies suggesting a low price-to-book can lead to a strong
stock price rise in the future. Price-to-book generally does
not measure financial services stocks well because of the
nature of the financial services business.
Over the past 80 years, the stock market's P/B has ranged
from less than 1 to 8 (both numbers are exceptions); it has
averaged about 1.6. During 1999, the P/B ratio for U.S.
stocks was just below 6 (vs. 4 for European stocks). The
ratio has declined since then, leveling off to about 3
beginning in the middle of 2002 through the first part of
2007 (vs. about 2.5 for European stocks). As of March 2009,
the S&P had a P/B of 1.5.
About the Author:
Cory Bowman is Director of Ops at the Institute of Business
Finance. IBF has helped thousands of members of the
financial services industry attain designations. For more
information about IBF, annuity courses, or fund certificate,