Sim­ple math can tell you a stock’s value

Stocks, not bonds, can be key to fu­ture prof­its

USA TODAY US Edition - - MONEY - Ken Fisher Ken Fisher is founder and ex­ec­u­tive chair­man of Fisher In­vest­ments. The views and opin­ions ex­pressed in this col­umn do not nec­es­sar­ily re­flect those of USA TO­DAY.

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.

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