OK, so we have discussed sales, operating income, EBITDA Earnings before interest, taxes, depreciation, and amortization. , and net income. Which is the best measure of a company? The answer, unfortunately, is NONE OF THE ABOVE!
If Stock A and Stock B are in the exact same industry, have the exact same revenues, costs, EBITDA and net income, which one is the better buy? We still can’t answer that question until we know two more pieces of data—the number of shares outstanding and the share price.
If Stock A and Stock B both had $5,000 of Net Income, but Stock A had 1,000 shares outstanding and Stock B had 100 shares outstanding, then Stock A is earning $5 per share ($5,000/1,000 shares) and Stock B is earning $50 per share ($5,000/100 shares). This is how Earnings per Share (EPS Earnings per share is calculated as the net income of a company divided by its total number of shares outstanding. ) is calculated—the Net Income divided by the number of shares outstanding.
Now we are finally getting to a point where we can start forming some expectation about a fair share price. Since Stock A has 10x as many shares issued, then it would follow that we would expect Stock A’s price to be 1/10 the price of Stock B.
Fortunately, there is a common metric called the PE RatioThe price of a stock divided by the earnings per share. This is a measure of how pricey the stock is and should only be used to evaluate a stock versus its competitors. , or Price to Earnings Ratio, that takes all of this into account. (We are just about done with all of these computations, but don’t worry, most financial websites, including howthemarketworks, does the math for you.) So, if Stock A is trading at $100 per share and we know it is earning $5 per share, then its PE is 20; if Stock B is trading at $750 per share and we know it is earning $50 per share, then its PE is 15. Finally, we can say that given these companies are in the same industry and all things being equal, Stock A is overpriced and Stock B is underpriced.
Never, ever, ever judge a company based on its stock price alone. Yahoo! and Google are both in the online search engine business and Yahoo! (YHOO) trades at $20 a share and Google (GOOG) trades at $500 a share. Does that mean YHOO is cheap and is the better buy? Absolutely NOT! You must look at the PE ratios of the 2 companies to put their share price into perspective of earnings and shares outstanding. If you still don’t get it, please re-read this chapter!
Assuming you understand the EPS calculation, the next obvious calculation after EPS (Earnings per Share) is Cash Flow per Share Cash flow per share is calculated as the cash flow from operations divided by its total number of shares outstanding. . This is simply the cash flow from operations that you see on the Cash Flow Statement divided by the number of shares outstanding. As you learned the differences between Net Income and Cash Flow, the Cash Flow per Share calculation eliminates the non-cash items that sometimes clutter the Income Statement that don’t represent real cash outlays by the company. Many Wall Street analysts feel Cash Flow per Share is the best way to truly value a company and therefore its stock.
Return on Equity
Return on Equity (ROE) is one more fundamental metric that must be mentioned as we try to evaluate a company’s performance. ROE is a measure of how much profit a company is able to generate from the money invested by its shareholders.
Think of it this way: if your teenager asked to borrow $1,000 to start-up a small business then chances are you would comply. When he came back in a few months to ask for $10,000, you would examine how well his company performed with the initial $1,000 before making the next loan. It makes such good sense that you might wonder why more people don’t use this handy little measure before pouring massive sums into a money pit masking as a company.
To calculate ROE, divide the profit by the initial investment. Using this example, if your teenager was able to make a $250 profit on the initial $1,000 investment, the ROE would be 25% ($250 / $1,000) which would be a very good ROE for most companies on Wall Street today.