P/E Ratios and Book Value INTRO: Obtaining growth at a reasonable price is a constant challenge for all investors. When analyzing stocks for possible purchase, many investors look at price to earnings ratio and book values to help determine if a stock is reasonably priced in the marketplace. Bruce Hagan, certified financial planner with RAI Investments and Corporate Securities Group is with us today to point out some problems with taking these measurements at face value. Q1: Bruce, let’s take P/E ratios first. Most everyone wants to know what the P/E of a stock is before they buy it. Define P/E ratio for us. A1: A price/earnings ratio is just what it sounds like: the price of a company’s stock divided by its earnings per share are net after tax earnings divided by the common shares outstanding. If a company is earning $2 per share and its stock trades at $40, its P/E is 20. Q2: On the surface that seems pretty simple. What’s wrong with taking this measurement at face value? A2: There’s some murkiness surrounding the earnings per share figure. Does it refer to last year’s earnings? This year’s? Next year’s expected earnings? The newspaper or your broker may quote the P/E ratio differently depending on which earnings they’re referring to and it can make a huge difference. If the company trading at $40 made $1 last year, is expected to make $2 this year and analysts are predicting $3 next year, the P/E quoted could vary from 40 to 13. You might think 40 is way too expensive and 13 is cheap, so you could make two totally different investment decisions depending on how it’s expressed. Q3: Even if one uses the current year anticipated earnings, those could come in differently than expected, right? A3: Of course, and be aware that the quality or make-up of the earnings is very important. What I mean by that is $2 per share in earnings may be misleading if $1 of it came from a onetime sale of a substantial asset. In that case, the earnings would look great at the moment, but that asset isn’t going to be there to produce revenue in the future. Conversely, if the company has recently take a write-off, earnings will look worse than they really are. It’s important to not only know the earnings but also what’s in the earnings. Q4: Good point. Now, let’s move to book value. How is that defined? A4: First you must understand the term "shareholder’s equity," which is defined as a company’s total assets minus its total liabilities. The book value of the company is simply the shareholder’s equity divided by the number of shares outstanding. (For example, if a firm has $15 million in total assets and $5 million in total liabilities, then the shareholder's equity is $10 million. If there are two million stock certificates, then the book value of this company stock is $10 million divided by 2 million or $5.00.) Q5: Again, that sounds like some important information. What’s wrong with taking this figure at face value? A5: The problem with book value is the term itself. It sounds as though there’s a book someplace with the stock’s true value written it, sort of like the Blue Book used by auto dealers to tell you how much your ’95 Toyota is worth. It sounds absolute and achievable. When an unsophisticated investor sees a stock with a book value of $9 trading at $6, they think, "Well, the company must be going through some rough times, but all the stock has to do is go back to book value and I make a 50% return." Next thing you know, the company might take a write-off and restate book value at $4. You have to know more about the company. The discussion offered above and in the movie should not be considered an endorsement by Florida State University. They are offered in the educational sense of providing thought-provoking information for ou14/2000r Web audience. Copyright shared with Florida News Channel (FNC), all rights reserved. Broadcast 12/3/1999