Conceptually,
investing is easy. When you're looking at a contender for
a spot in your portfolio, it's all about two simple
questions:
To answer the first question, you need to determine
whether the company is healthy (with manageable debt and
ample cash, for example) and growing. You want to see
talented management, an impressive track record of
performance, competitive advantages, and the promise of more
growth.
The second question can be trickier. After all, even the
best stock analysts and investors can't do more than come up
with an educated guess about what a stock should be worth.
Still, you shouldn't invest in a company, no matter its
quality, if its stock price seems to have gotten considerably
ahead of itself. Ideally, you want to
buy at a substantial discount to intrinsic value.
One route you can take is to spend the time and energy
learning
how to value stocks carefully. But there's a simpler way
to get an initial ballpark estimate, which will help give you
a reasonable start to your stock research.
Do it yourself
Here's the quick method I use sometimes: Look up a
stock's historical price-to-earnings ratios (P/E), which you
can do with our
Motley Fool CAPSservice. (Type in your ticker and go to
the tab labeled "Ratios.")
Here'sthe data for
Cisco Systems (Nasdaq: CSCO). If Cisco's P/E
has been between 11 and 26 over the past five years, it
doesn't look like a screaming bargain with a P/E of 23. On
average, the company's P/E over the past five years has been
21.6.
Next, grab the company's expected earnings per share (EPS)
for the coming year. It's sometimes called the "forward EPS."
At CAPS, I learned that
the average expected EPSfor Cisco for fiscal 2011 is
$1.38.
So now you take the expected EPS of $1.38 and the
five-year average P/E of 21.6, and multiply them, getting
$29.81. That's the price you might expect Cisco to be trading
around in fiscal 2011, and it's more than 25% above where the
stock closed yesterday.
Making sense of it
Now that's no guarantee, of course. Cisco may well
surge strongly in the coming year, or it could stagnate or
even fall sharply. But this is a way to get a rough idea of a
reasonable value to expect. The reasoning behind it is this:
The current P/E can fluctuate wildly as economic conditions
change, but the average tends to stay more stable. Therefore,
it's arguably a better measure for long-term investors to
use.
Check out these examples:
Company
CAPS Stars
(out of 5)
5-Year
Avg. P/E
Next Fiscal Year EPS (Estimated)
Possible
2011 Price
Recent
Stock Price
American Express (NYSE: AXP)
***
16.7
$1.95
$32.57
$34.88
Kraft Foods (NYSE: KFT)
****
20.2
$2.15
$43.43
$26.70
Nokia (NYSE: NOK)
****
15.0
$1.06
$15.90
$13.03
Johnson & Johnson (NYSE: JNJ)
*****
17.8 Continued... |