Stock Valuation Overview for a Fund Certificate

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, visit www.icfs.com