<FOOLISH FOUR PORTFOLIO>

Stock Picking with the P/E
Or "Why we like the Foolish Four"

by Ann Coleman (TMF [email protected])

Reston, VA (February 22, 1999) -- In contrast to the simple, two-factor stock-picking strategy we use to determine the Foolish Four stocks, most long-term investors try to establish a value for a particular company's stock and then buy only if the current price is below that value.

There are many, many ways to arrive (or attempt to arrive) at a stock's value, and I promise not to bore you with them all, or even a small fraction of them. For those of you who are thinking about the possibility of moving beyond a simple, mechanical strategy like the Foolish Four, though, the P/E, probably the most quoted financial ratio, is a good place to start.

Last week we worked on calculating it. This week we will explore what it is good for and some of the many ways you can work very hard at beating the Foolish Four.

If stock value is based on the company's earnings (profit), why should one company be selling for 8 times its earnings and another for 67 times its earnings as we saw on Friday?

Part of the answer is that although the P/E is calculated using current earnings, stocks are not really valued on current earnings but on what the buyer thinks the company will earn in the future. Why should you care what a company earned last year when you weren't an owner? You care what it can earn while you own it, right?

So while the P/E expresses the stock's price in terms of what a dollar's worth of earnings costs the buyer, the thing the buyer really wants to know is: what are the company's future earnings, the ones I will benefit from, costing me?

Obviously, no one knows for sure -- that's why stock prices can be so maddeningly variable. Of course, supply and demand drive price changes, but demand is tied to the perception of a company's future earnings.

Say you have a choice between two similar companies. In fact, for our example, we are going to assume that they are exactly the same down to their current earnings per share. There's only one difference, and that is in what they are expected to do in the future:

                          Company A     Company B
Actual Earnings last year:  $0.50         $0.50
Est. Earnings this year:    $0.75         $0.63
Est. Earnings next year:    $1.13         $0.78

We are assuming here that we are in the first quarter of the year so that we have last year's earnings, which are identical, and two years' worth of estimated earnings. (It gets complicated when you get into quarterly earnings, so we will ignore that for now.)

Both companies are selling for $12.50 a share, so each has a P/E of 25 (12.5/0.5 = 25). You have to buy two shares to "get" a dollar's worth of earnings. If all you knew about Company A was that it was exactly like B, the fact that they are priced the same might seem reasonable. But if you expected Company A to have higher earnings this year and next, as we show above, you might think that it was a better investment than B, even though the prices are identical.

Being a rational investor, you would buy it, and as word of the higher anticipated earnings moved through the marketplace, others would make that same rational decision. They would buy and others would buy and eventually all of that buying would drive the price right up to where the market perceived that Company A was no longer a bargain relative to B.

In fact, company A, which is growing earnings at the rate of 50% per year, could easily be expected to be selling at for twice as much as Company B, which is only growing earnings at $25% a year.

Why? Well, in two years, each share of A will be generating $1.13 worth of earnings, while B's shares will only be generating $0.78. (We are assuming that the analysts are right about each company's estimated growth, which is a whole 'nother question, of course.) If such growth continues, in 5 years, company A will be earning $3.80 a share, compared to $1.53 for company B. Over that five year time period, A will have generated somewhere around $9.89 in total earnings, compared to $5.13 by company B, and that discrepancy will continue to widen as long as they maintain their different growth rates.

All of that money that A is earning can either be paid out as dividends and/or reinvested in the company to help it grow faster. The company might use the money to buy other companies and add their earnings to the bottom line, they might use it to expand and build more widgets, or they might use it to reduce their prices and drive their competitors out of business. Whatever they do, it is cash, and cash is both the power and the glory when it comes to business.

For a more exact discussion of the P/E and a company's growth rate, you may wish to read our discussion of Foolish Ratios.

Heads up! Tonight and tomorrow night just after sunset you can see a rare and beautiful celestial event as the planets Venus and Jupiter come into conjunction. The closest approach is tomorrow, but it should be pretty cool tonight and Wednesday, too. If you look to the southwest you can easily pick out Venus, which is the brightest-by-far pinpoint in the evening sky. To the left is Jupiter, which looks rather puny next to the ultra bright Venus, but is actually fairly bright when not so grandly outshone. Use binoculars if you have them for a spectacular sight. If you are very early and look down and right from Venus toward the horizon you might even catch a glimpse of elusive Mercury. It will be the brightest object between Venus and the spot where the sun went down. Mercury will be more visible toward the end of the month and in early March, but catch it quick because it never sticks around for long. FYI, Saturn is the bright, yellowish "star" on the line between sunset, Venus and the quarter moon, but if you want to see Mars you will have to get up real early (shudder) or wait until later this spring (my personal plan).

Fool on and prosper!

Today's Stock Lists | 1998 Dow Returns

02/22/99 Close

Stock Change Last -------------------- CAT +1 7/16 46.50 JPM +2 1/2 113.13 MMM +1 3/4 78.50 IP +1 1/8 43.19

Day Month Year History FOOL-4 +2.59% 5.97% 3.75% 5.29% DJIA +2.28% 2.07% 4.19% 3.78% S&P 500 +2.66% -0.59% 3.81% 4.06% NASDAQ +2.56% -6.54% 6.81% 8.27% Rec'd # Security In At Now Change 12/24/98 24 Caterpillar 43.08 46.50 7.94% 12/24/98 9 JP Morgan 105.51 113.13 7.22% 12/24/98 14 3M 73.57 78.50 6.70% 12/24/98 22 Int'l Paper 43.55 43.19 -0.83% Rec'd # Security In At Value Change 12/24/98 24 Caterpillar 1034.00 1116.00 $82.00 12/24/98 14 3M 1030.00 1099.00 $69.00 12/24/98 9 JP Morgan 949.62 1018.13 $68.51 12/24/98 22 Int'l Paper 958.12 950.13 -$8.00 Cash $28.26 TOTAL $4211.51 </FOOLISH FOUR PORTFOLIO>