Tell the Story With Numbers

Quantitative measures, those that rely on numbers, are especially valuable in making comparisons. Quantitative measures are usually ratios that show the relationship between numbers on a company's financial statements, which are invaluable in understanding how a company operates. When you're ready to compare companies, move on to reputable secondary sources such as Standard and Poor's or Value Line, which are often available free through public libraries. They save time because they consolidate current and historical financial information into easy-to-read, standardized formats.

Sales. Healthy sales drive business, yet they are an incomplete picture. Companies with similar sales are likely to vary in profitability, depending on cost of goods sold, efficiency of operations, mergers and acquisitions, plans for new products, etc. (We'll talk more about profitability in a moment.) Like most quantitative measures, the amount of sales by itself is not important; it's how sales compare to previous sales. As an investor, you want to see sales that increase over time, that show a steady pattern of growth. Be sure to view sales as a first, general indicator that is part of a larger picture.

Earnings per share. While sales begin the story, earnings per share (EPS) gets right to the bottom line. Earnings are profits--as an investor, you want to know how those earnings translate into profit for you. EPS tells you how much profit goes to each share of common stock. It is calculated by dividing net earnings by the number of outstanding shares of common stock. Over time, an increasing EPS implies that the company is well run. For example, using the 2004 10-K report from http://www.sec.gov for the McDonald's Corp. (NYSE: MCD), EPS is figured this way:

In 2004, McDonald's earned $1.79 for each share of outstanding common stock.

As with most ratios, EPS can be calculated in a number of ways. It's usually reported as a trailing indicator, meaning that it uses last year's earnings. Forward EPS uses projected earnings. Be sure you are comparing "apples with apples" when you use EPS to compare companies.

Profitability. A company's profitability can be determined in a few ways, but they all result in a percentage that lets you know how much of sales the company retains as profit. From the income statement, various levels of income are divided by sales. Gross profit margin, for example,tells you what percentage of sales is left after subtracting the direct cost of producing the goods. Net profit margin, the so-called "bottom line," considers all aspects of running the business, summing up in one number how well the managers extract a profit from each dollar of sales.

Let's use McDonald's as an example again. In 2004, McDonald's Corporation had total sales of $19.065 billion (billion!). Net income was $2.279 billion. (We called it "net earnings" before. We could have said "net profit" too.) Net profit margin, therefore, was 12% (2.279 / 19.065). Put another way, McDonald's had a net income of 12 cents of every dollar in sales.

Return on equity. Another measure of management's skill is how well it uses the money invested by stockholders. A company sells shares of stock, and then what? Simply stated, the money helps cover costs, which result in sales, which result in profit. Return on equity (ROE) measures management's skill in turning your investment into profit. It is calculated by dividing net income by book value. A high ROE, compared to others in the industry or to past ROEs, means that management is running the company more efficiently.

Price-earnings. By far and away, price-earnings (PE) is the most popular measure of the value of a stock. Some investors rely on it almost exclusively! It differs from the ratios mentioned thus far in that it takes stock price into consideration, shedding some light on whether the stock is overvalued or undervalued.

PE is calculated by dividing a stock's price by earnings per share (see above). If a share of Company A's stock sells for $60 and it has an EPS of $3, then Company A is trading at a PE of 20 (60 / 3 = 20). This tells us that investors are willing to pay $20 for every dollar of earnings. PE is often referred to as the multiple; in our example, it indicates that investors are willing to pay 20 times the current EPS.

Why would investors be willing to pay such a premium? Because they expect the stock to return more in the future. A PE that is higher than the industry average means that investors expect the company to grow and be quite profitable. A PE that is lower than the industry average means that investors have low expectations for performance.

Always note how a particular PE is figured--with a trailing EPS, a forward EPS, or some combination--and be sure to use the same formula for every stock you compare it to.

Price-earnings and growth. Many investors now use the price-earnings and growth (PEG) ratio because it goes one step further than PE. Recall that a low PE indicates that investors have low expectations for a stock's profitability. Using PE, it is difficult to gauge whether those expectations are valid or whether the stock is simply undervalued. By incorporating growth into the equation, PEG can help us decide.

PEG is calculated by dividing the PE by annual EPS* growth. A stock with a PE ratio of 40 and projected earnings per share growth of 10% has a PEG of 4 (40 / 10 = 4). In general, the lower the PEG the better; investors would be paying less for each unit of earnings growth.

PEG is a ratio with a ratio in the numerator and another ratio in the denominator! If you're becoming overwhelmed by the numbers, keep in mind that ratios are little more than simple division problems that compare the numbers in financial statements. Once these comparisons, which are really percentages, are calculated, it's easy to compare them to similar companies. Figuring PEG may take a few more steps, but the effort is rewarded by better information about a stock's potential.