Investors value stocks based on one question: If I put my money into this company, what are the chances I'll get a better return than if I invested in something else? It's a matter of risk vs. reward. The safest investment is a U.S. Treasury bond because its return is guaranteed by the "full faith and credit" of the federal government. (See our Bonds section for more on how these securities work.) A stock's value proposition starts there -- how much more will it return than a Treasury bond and at what risk?
When you buy a stock, your return is a stream of earnings over time -- which is hardly guaranteed. The more reliable that stream, however, and the more quickly it grows, the more investors will be willing to pay for it (see applet above). Your traditional electric utility has reliable earnings but utilities don't grow very fast, so they tend to be pretty sleepy stocks. Microsoft's earnings, on the other hand, are both steady and fast-growing, which is why there are more than a few secretaries in Redmond, Wash., who count their net worth in millions.
In order to evaluate companies against each other (and against themselves), investors long ago developed a measure called the price-to-earnings ratio, or P/E. It's derived by dividing a company's price per share by its earnings per share. If a company has a P/E ratio of 20:1 (usually displayed as just 20), for instance, that means investors are paying $20 for every $1 of earnings. If the P/E is 18:1, they're only willing to pay $18 for that same $1 profit. Most people only use the top number when referring to a company's P/E, as in Colgate-Palmolive has a P/E of 24. The ratio is also known as a stock's "multiple," as in Gillette is trading at a multiple of 26 times earnings. Translation? Going back to our original example, investors are paying more these days for a slice of Gillette's profits than Colgate-Palmolive's.
A company's P/E fluctuates with investor perceptions about how quickly its earnings will grow in the future. That's why two companies with the exact same earnings per share over the past year may have different multiples. If Company A and Company B each earn $1 a share, but Company A is trading for $20 and Company B is trading for just $18, the market is making a judgment on their earnings prospects. Based on any number of factors -- company health, outside competition, better management, the economy, the outlook for the sector -- investors think Company A's earnings are better poised for growth. Consequently, they're willing to pay $2 more right now to lay claim to them.
OK, so we still haven't really answered the question -- what is a cheap stock? For that we have to look at a stock's behavior over time. Most established companies trade up and down in a range depending on how investors are weighing their earnings prospects. Sometimes disappointing news -- a lackluster quarterly-earnings report, for instance -- can depress the price for a period of time. Other times good news sparks a flood of investor interest.
This ebb and flow is reflected in the P/E, which can be compared both to a company's historical range and that of other companies in its industry. It can also be compared to the market as a whole. For example, in November 2002 Boeing was trading at about 11 times earnings projections. That looked cheap compared to the average P/E of the roughly 30 publicly traded aerospace and defense companies, and considerably cheaper than the average S&P 500 stock. But a little more research would tell you that these companies often trade at a discount to the broader market because their earnings are so cyclical. And Boeing was faced with a huge decline in commercial-aircraft orders thanks to the recession.
Lockheed Martin, on the other hand, was trading at around 19 times earnings projections, which made it look expensive. But Lockheed Martin gets a huge percentage of its revenues from sales of fighters and other defense-related wares, and its products have been in considerably more demand since the war on terrorism began. Faced with this evidence, you might conclude that Boeing was a bargain if the economy began to turn around. Lockheed Martin might look fully valued, but ripe for the picking if its price falls temporarily.
The object of investing is to buy low and sell high. And as you can see, that often means looking for stocks that are temporarily out of favor. If you buy stocks near the top of their range, the danger is they will reverse course and tumble downward. If you buy near the bottom -- or when the stock is cheap relative to its true potential -- you can enjoy the full ride back upward. (The catch, of course, is to do careful research so you can be confident the stock will, in fact, head north once again.)
