When P/E ratios just won’t cut it

Other ways to value stocks find favor

A long time ago, in a market far, far away, price-to-earnings ratios were considered an adequate measure of a stock’s intrinsic value. But with the bull market now more than eight years old and with stock prices soaring, P/E ratios have become so astronomically high that some analysts today question whether they are an accurate gauge of a stock’s worth.

By old Wall Street standards, stocks with P/Es of 20 were overvalued and not considered good growth prospects. But that rule of thumb has less relevance in today’s market, when even cyclical stocks such as Minnesota Mining & Manufacturing Co. (NYSE: MMM) trade at a P/E of roughly 23.9.

As a result, analysts and fund managers are relying more on alternative methods of valuing stocks. The following is a glossary of such terms, as well as more basic definitions:

  • Price-to-earnings ratio or P/E ratio. The P/E ratio, also called the multiple, is still the most common way to value a stock. It is the price of a stock divided by its earnings per share. It’s usually calculated using analysts’ consensus estimates of next year’s earnings, known as the forward P/E.
    For example, a stock selling for $20 that earned $1 last year has a trailing P/E of 20. If that same stock has projected earnings of $2 a share, it will have a forward P/E of 10.
  • Book value. This is the net asset value of a company’s securities. It is calculated by figuring a company’s total net asset value, then dividing that amount by the number of shares of common stock, shares of preferred stock or bonds outstanding. Book value is one tool used to determine if a stock is underpriced and therefore a good buy.
  • Dividend yield. The annual rate of return on an investment expressed as a percentage. For stocks, it is the annual dividend divided by the purchase price. It’s also called the current yield.
  • EBITDA. The acronym stands for earnings before interest, taxes, depreciation and amortization. Also called cash flow, it is figured by taking a company’s net income, adding depreciation and amortization, then subtracting capital expenditures (how much money the company invests each year on plant and equipment). EBITDA is used primarily to value broadcasting and telecommunications stocks, companies with large investments in capital improvements.
  • Price-to-sales ratio. A stock’s capitalization divided by its sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a per-share basis.

If you want to find out more about financial terms on the Web, visit www.investorwords.com.

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