Simple math can tell you a stock’s value

Stocks, not bonds, can be key to future profits

How do you know if a stock is a good deal? Or the stock market?

The industry bombards us with complicated analysis and unreadable, unnecessarily intimidating jargon. How can you simplify it to what matters?

The easiest way to fathom a stock’s (or the market’s) value is to think like you’re buying the whole business. What’s the price, and what will you get back in the long run?

The price part is easy. Stock prices and broad indexes such as the Standard & Poor's 500 are quoted widely. For the “get back” part, many use a figure called the price-to-earnings ratio, or P/E. It’s a stock or index price divided by its earnings per share. Some use the past 12 months’ earnings. Others use estimates for the next year (which I prefer, called forward P/Es). If a P/E is 12, you’re paying $12 for every dollar of earnings. Most pundits presume stocks are expensive when P/Es are high and cheap when they’re low. They think high P/E implies low return potential (and vice versa). But there is a better two-step way.

First, flip it by dividing earnings by price. Or, just look up the stock’s P/E ratio at Google Finance and invert it (divide 1 by the P/E). Currently, the S&P 500’s forward P/E is 16. So divide 1 by 16, and you get 0.0625 or 6.25 percent. This is the S&P 500’s “earnings yield.” It’s what you would get each year after tax, forever, if the S&P 500 were a company, you owned it all – 100 percent – and earnings never grew.

Second, to sense value, compare them to long-term bond interest rates. Ten-year U.S. Treasurys currently pay 2.73 percent. Stocks’ earnings yield is much higher, so a better long-term deal. BBB-rated corporate bonds – investment grade for the average public company, not too risky – yield 4.45 percent. That’s pretax, so in an average family with a 26 percent tax rate (state and federal) that’s 3.3 percent after you take out taxes. Stocks’ 6.25 percent is almost twice as high. So owning the S&P 500 earns a better return than lending to these same companies.

As mentioned earlier, the earnings yield is your forever, after-tax return from all stocks if earnings never grow. But they do grow! Businesses adapt in the long term, capturing technological change and innovation. New inventions bring new sources of corporate earnings. Think about how many products use a simple microchip. Firms routinely dream up new ways to collide evolving technology with basic products and services. Medical progress is unending. It’s all future potential profit.

When you own stocks, you own that future. When you lend by owning bonds, you don’t. You get fixed interest payments. If you need long-term growth to fund your long-term retirement, stocks are the surest way to get it. Earnings yields tell you this future is a bargain today.

Of course, that says nothing about stock prices a year from now. Could be higher or lower. Those wiggles are the short-term and all about society’s varying sentiment toward owing volatile assets. This framework is just how to measure value in the long term and a great way to think about value.