PE ratio: Is that stock overpriced?

$5700

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Previously I wrote about the common misperception that a high-priced stock is “expensive,” while a low-priced stock is “cheap.”  I said that stock price doesn’t matter.

This raises the inevitable question:

Q. How can you tell if a stock is expensive or cheap?

A. Use the Price-Earnings Ratio (aka the “PE Ratio”)

The PE ratio is computed by dividing the stock market price by earnings per share*. But it’s not that complicated: PE Ratio is often listed near the stock price.  For example, check out Apple’s PE Ratio here.  As I write this on April 20 it is 16.75.  That means each dollar of net income will cost you $16.75 worth of stock.

An average PE Ratio these days seems to be in the mid-teens.  You can consider high PE’s to be expensive and lower PE’s to be cheap.  Therefore, Apple stock, compared to its earnings, is just about average.  That’s right: Apple stock, trading at $593.85, is moderately-priced!  (Pre-disclaimer – please read this whole article before calling your stock broker.)

Hewlett-Packard‘s stock price is $24.85 right now.  But its PE ratio is just 8.77.  Each dollar of net income will cost you just $8.77 worth of stock.  Hewlett-Packard stock, compared to its earnings, is cheap.

Dell‘s stock price is $16.07 right now.  PE Ratio is a low 8.52.  Dell and Hewlett-Packard’s PE ratios may be so similar because the companies’ products are so similar.

Google is trading at $602.24 today.  PE ratio is a moderate 18.25.

Let’s check out some other industries.

Exxon Mobil is trading at $85.44 a share. PE Ratio is 10.15.  ConocoPhillips is trading at $73.52.  PE Ratio? a low 8.19.

Goldman Sachs is trading at $113.71 a share right now.  PE Ratio is a moderate 16.82.  Citigroup is cheaper.  While the stock is trading at $34.68, the PE Ratio is just 9.67.

Berkshire Hathaway is trading at $118.975 today.  Think that’s expensive?  Think again.  The PE Ratio is a moderate-to-high 19.14.  Investors are willing to pay a little something extra to have Warren Buffet working for them.

Let’s look at some really high PE’s:

Mall retailer Abercrombie &Fitch‘s stock price is $48.71.  PE is a high 34.44.  That’s expensive.

Manitowac Corporation  makes cranes and food service equipment. Its stock is trading at just $14.64 but its PE Ratio is a humongous 71.62.  “Low” stock price, high PE: an expensive stock.

While the PE Ratio is good measure for how expensive a stock is, it does not explain why the stock is expensive or cheap.  A stock could be expensive (with a high PE) because investors are so frenzied to buy it that they don’t care about its performance – an obvious sign to stay away.  It could also be expensive because investors have high expectations for the company – a good reason to buy.

And a stock could be cheap (low PE) because investors undervalue the company’s performance – this would be a good opportunity to buy low now and sell high later.  On the other hand, the stock could be cheap because it is a really bad investment.  It could go either way.  Take a look at Dell and Hewlett-Packard.  Their PE’s could be low because investors undervalue these companies’ prospects, or because they’re not good investments.

BTW: No one should ever make big money decisions based on what some stranger posts on the internet.  This blog was not written to give you advice to buy or sell any stocks.    I don’t own any of these stocks right now.  Follow this blog, read other blogs, read books, check out www.finance.google.com, educate yourself, make your own decisions, and make your own money.  Etc. etc. etc.

*  You can use earnings per share for the past year, or even a prediction of earnings per share for the coming year.

[Image: $5700 by AMagill, on Flickr]

 

Stock price does not matter

Shout 2

Accountinator! Say it isn't true!

That’s right. The fact remains:

Stock price does not matter.

Huh?

Many people think that the higher a stock price, the more “expensive” a stock.  The lower the stock price, the “cheaper” a stock.  Right now, as I write this (on April 19, 2012), Apple stock is trading at $595.55 a share.  Google is at $606.66 a share.  Berkshire Hathaway (Class A) is at $118,700 a share.  On the other hand, Research in Motion is at $13.55.  Nokia is at $3.86.  Qiao Xing Mobile Communication is at 88 cents.  It just doesn’t matter.

Judging that a stock priced over $100 is “expensive,” while a stock priced below $20 or even below $1 is “cheap,” is a dangerously simplistic approach to investing.  In fact, from an investor’s point of view, Apple stock ($595.55 a share today) looks “cheap,” while Nokia ($3.86) is “expensive.”

You see, stock shares are a way of splitting up a company into equal pieces that can be sold to shareholders.  The actual number of shares issued is actually quite arbitrary.  Therefore, you may have a small company split up into many many shares; this would result in a “low” price because each share is pretty small.  On the other hand, you may have a large company split up into very few shares; this would result in a “high” price because each share is very large.  Think of a large pizza pie split into two slices, and a small pizza pie split into 32 slices.  Would you describe the two large slices each as “expensive” and the 32 small slices each as “cheap?”

Therefore, to truly judge whether a stock is “expensive” or “cheap,” don’t just look at the stock price.  Consider what you’re getting for your money.  How large a share of the company does your stock actually represent?  Next I will show you how to determine that Apple is actually quite cheap, and Dell is actually exorbitantly expensive.

[Image: Shout 2 by andrew_mc_d, on Flickr]

 

Transparency

Lookin' Outside My WindowAccountants like to talk about transparency, the principle that financial statements should give a clear and accurate portrait of a company’s performance.

Accounting is important because you need a transparent view of your business’s performance.  What are your sales?  Your expenses?  How profitable is your company?  What assets do you own?  How much cash do you have on hand?  How much do you owe?  Is your performance improving?  Too often, and especially in small businesses, I see and hear about entrepreneurs who “wing it” and can’t answer all of these questions.  They’re driving with their eyes closed.

Almost anyone should be able to keep state-of-the-art accounting records appropriate for their business, with very little training or effort.  These records will allow you to quickly look up and know all of the information that you need about your business, helping you make smarter and more profitable decisions.

I’ve written about two easy tools for keeping your own records:

  • For a very small business with few transactions, I developed a simple template on Google Docs.
  • More advanced companies should try the open-source program GnuCash.  Free download here.  Quick demonstration video here.

Getting a transparent view of your business requires more than keeping reliable books.  It also requires understanding your books. Keep close tabs on your profitability, solvency, liquidity and productivity, and work to improve them.

[Lookin’ Outside My Window by dlco4, on Flickr]

 

Finding a good accountant

Finding someone you can trust.

Studies show that accountants are often a business person’s most trusted advisor. Your accountant will have access to your most personal financial information.  Be careful.

This is where the Certified Public Accountant can help.  The highly-respected CPA credential indicates that the holder has passed the challenging CPA exam and is licensed in at least one state.  In most states, a CPA must now also earn 150 college credits (equivalent to bachelor’s and master’s of science degrees) and complete a working internship for at least two years.  CPA’s must also adhere to ethics guidelines that are enforced by the AICPA and state board of accountancy.  States also require CPA’s to take courses every year to keep current with new rules.

Before you can trust your accountant, however, make sure that they know what they’re doing.

Finding someone with knowledge and experience.

The CPA credential is focused on independent auditing of companies and financial reporting, rather than taxation or advising small businesses.  Only a small portion of the CPA exam involves taxation and advising small businesses.  Therefore, an accountant who is a CPA is not enough.  You also need to make sure that your accountant is experienced and knowledgeable in both taxation and advising small businesses.  A bonus is to find a CPA who specializes in your type of business.

The IRS requires tax preparers to “register” their services.  However, IRS rules exempt CPA’s, and many other tax preparers from actually taking any kind of qualification exam.  Therefore, registration with the IRS does not necessarily indicate that an individual is has sufficient knowledge and experience to prepare your taxes.

A tax attorney is usually well prepared to handle your tax situations, be they mundane typical filings or more difficult matters.  However, tax attorneys can be more expensive than other accountants.

To find a good accountant, your best bet is to ask around.  Ask for tips from colleagues in your industry or other local business people you know.  Then carefully interview a prospective accountant, and ask him or her about the services that they typically provide, and for the names of other clients.  Speak with some of those clients and other people who have known your prospective accountant for a long time.  Make sure your accountant is familiar with local tax laws in your state and city.

If your business is small, your best bet will be either a sole practitioner or a small firm (typically two to five partners).  A sole proprietor is usually more accessible.  However, a small firm can usually offer a broader array of services, more thorough quality control, and access to a tax attorney.

 

A simple bookkeeping spreadsheet in Google Drive

I developed a simple Google Drive template that will allow you to keep a set of books for a simple business.  This will work for a simple business that has a few similar transactions a month.  You can access the template here:

https://docs.google.com/spreadsheet/ccc?key=0AuBVuYUx84SfdHh2TW52d0Jmd3FINmQ0TGlUUXp4dlE&usp=sharing

This is a view-only file in Google Drive. It cannot be edited. To make an editable copy, click on the above link. If you’re not already logged into your Google account, then do so. In the open spreadsheet, click on File and then click on Make a Copy. An editable copy of the file should then appear on your screen, and has been saved to your Google Drive.

The following video shows you how to use the template:

Here is the same template in Microsoft Excel format: https://accountinator.com/2012/07/25/simple-accounting-spreadsheet-excel/

Check out my new e-course, Accounting for Startup Businesses. It includes training using open-source accounting software. First two lessons are free.

Both spreadsheets updated on April 21, 2013.

 

Extraordinary gains and losses almost never happen

Accountants say this wasn't extraordinary.

Extraordinary gains and losses are gains and losses that are considered both unusual and infrequent. Unusual, in the sense that you wouldn’t have reasonably expected this event to happen.  Infrequent in the sense that you don’t expect this event to happen again.  US Generally Accepted Accounting Principles (GAAP) are highly restrictive about extraordinary items; these apocryphal gains and losses almost never happen.

Remember when the City of New Orleans was wiped out by Category 3 Hurricane Katrina?  Not extraordinary, because hurricanes might be unusual, but they’re not infrequent.

September 11 terror attacks?  Also not extraordinary.

My favorite example is an elephant escaping from the zoo, travelling 100 miles, breaking into a light bulb factory, and then wrecking the inventory.  Now that’s extraordinary.  Think of something that will probably never happen, so much so that you wouldn’t even bother buying insurance for it, and if it happens anyway.  That might be extraordinary.

In fact, there are almost no extraordinary items to be found in companies’ financial statements, as I wrote in this article with my colleague Dr. Theresa Henry,  This is just a topic taught in accounting courses and covered by the CPA exam.  Among us accounting professors, it is a favorite obscure topic on which to ask multiple choice questions.

In case you’re curious, an extraordinary gain and loss, should one every happen, would be reported at the bottom of the income statement, separately from all other items.  These items are reported “net of taxes,” i.e. the net effect of the gain and losses, after subtracting the related income tax benefits or costs, is reported.

[Image: New Orleans in Hurricane Katrina courtesy of Wikipedia Commons.]

 

Why a $10,000 gig might not yield you so much

Homeless sleeping on the sidewalkIf you are self-employed,* then your income will be subject to two forms of federal taxes (not to mention state and local taxes): federal income tax and self-employment tax.

Federal income tax

Federal income tax is assessed at the rate on your income tax return.  This varies based on your family income. In the US, our tax system is progressive – the more you make, the higher the percentage you are supposed to pay .  Also, single taxpayers usually pay higher rates than married taxpayers with children.  Deductions, such as charitable giving, mortgage interest, and state and local taxes, may lower your tax rate.

You should know your marginal tax rate.  This is the rate of federal income tax on one additional dollar earned.  Ask your accountant or look it up in your tax preparation software.  Use this rate to consider how much income will be left from a particular project after Uncle Sam has finished with you.  For example, if my marginal tax rate were 33%, then a new $10,000 consulting project will only yield $6,700 in take-home (10,000 – [33% x 10,000]).

Self-employment tax

Self employment tax in 2011 is 13.3% (10.4% for Social Security and 2.9% for Medicare).  The first $106,800 is taxed at the full 13.3%, .  Any additional income is only hit with Medicare Tax, 2.9%.  Taxpayers who have already paid social security with their wages may be exempted from some, or all of their Social Security tax).

Let’s return to my $10,000 consulting project.  Suppose I haven’t paid any social security this year.  Then I will also need to pay an additional $1,330 ($10,000 x 13.3%) in self-employment tax.  My net yield will be $5,370 ($6,700 – 1,330) after federal taxes.**

Any state income tax will further reduce your yield.***

When you take whatever money is left and spend it, you will probably be paying sales tax on whatever you buy.

Learning income tax rules and careful planning can reduce these taxes.

For one thing, carefully document your expenses and take all of the deductions that you can.

You also may be able to time your income and expenses so that you pay taxes on it later, rather than sooner.  For example, if you receive a check on December 31, it gets taxed this year.  A check received on January 2 of next year gets taxed next year. On the other hand, an expense incurred this year can be deducted now.  An expense after December 31 can’t be deducted until next year.

The moral of the story: knowing your tax situation and basic tax rules can save you a lot of money.

*I wrote this post about a self-employed individual, rather than a corporation.  If you choose to incorporate, you will be subject to corporate taxes and also individual taxes on dividends, not to mention income taxes on salaries you take from the corporation.  Incorporating may reduce or increase your taxes, depending on the situation.

**This kind of motivates me to stop working and spend more time with my family.

***A good reason to leave New Jersey and move to Texas or Florida.

[Image: Homeless sleeping on the sidewalk by Franco Folini, on Flickr]

 

The Costco Delusion

“Look at how much I saved at Costco!”

Costco has some of the lowest markups in the retail industry. That, combined with the huge company’s buying power, allows the company to offer super-sized products at very competitive prices.  Those low prices are real.

My favorite Costco purchase happened when we were renovating our backyard.  To create a privacy barrier, the local nursery was asking $79.95 for 6-foot arborvitaes.  Instead, I bought 12 little 2-foot leyland cyprus for $12.99 each.  Three years later, they were well above 6 feet each.

When you’re shopping at Costco or other warehouse retailers, beware of two problems.

First, Costco packages are usually much larger than in other stores.  You might normally buy one loaf of bread but Costco forces you to buy two.  Fruits and vegetables, paper towels, office supplies, you name it, Costco sells these in huge packages.  There’s little point in buying a bushel of grapefruits if half of them are going to rot before you have a chance to eat them.  Don’t buy more than you need.

Second, Costco is full of stuff that you don’t need at all.  Mango salsa might taste great in the samples stand, and the designer clothes and small home appliances look very appealing in the store.  A day at Costco is full of temptations to add these items to your over-sized shopping card.  Enjoy the free samples, sure. But avoid the temptation.  Don’t buy things you don’t need.

 

How much TurboTax actually cost me: $22.27 above budget

As I wrote before, I was planning to use TurboTax to prepare my taxes.  I’m quite cynical about all of the extra charges that Intuit hits you with and figured that it would cost me $73.97.

I wound up using TurboTax for the iPad.  Federal filing (including e-filing) cost $49.95.  State filing (including e-filing) cost $39.99.  I was also charged sales tax of 7%.  Total cost came to $96.24, which was $22.27 above budget.  This was the cost e-filing, which I hadn’t originally considered.

TurboTax for iPad worked well.  There were several easy ways to download my prior year’s tax return onto the iPad.  Waiting times weren’t too long.  I didn’t encounter any bugs or apparent errors.  The input of business expenses was somewhat awkward because I was unwilling to pay extra for an upgraded version.

 

Go paperless

Save the planet.
Don’t keep drawers full of paperwork.  Instead, scan whatever papers you need into your hard drive.  Benefits:
  • Save trees
  • Find your files more easily
  • Avoid losing important papers in a disaster
  • Takes up less physical space
  • More convenient access to your files
Develop a simple filing system.
  • Set up folders to naturally classify your papers.  For example, sales invoices can go in one folder and rent bills in another.
  • In each folder, mix scans with other relevant documents, such as MS-Word files.
  • Save all scans in the same format – PDF format works.
  • A 300 DPI setting in color is usually clear enough for most papers without hogging too much disk space.
  • Use a consistent naming system.  For example, I name each file according to the date: YearMonthDate.  A memo dated “February 18, 2011” would be named “20110218.”  Then, alphabetized files will also appear in chronological order.
  • Proprietary programs for filing scanned documents (such as PaperPort) don’t add much value over simply viewing your files in Windows Explorer.
  • A cloud-based system like DropBox will back up all your files and make them available online, on a tablet and on other computers.