<FOOLISH FOUR PORTFOLIO>

More on the P/E
Ready to give up yet?

by Ann Coleman (TMF [email protected])

Reston, VA (February 24, 1999) -- The Foolish Four strategy is so simple -- I just love it! You do a little math, pick a few stocks, then ignore the whole thing for a year.

After all, there are things to do in this life besides watch stocks dance around, their prices springing all over the place in response to who knows what tune. Then again, those stocks can be kind of fascinating....

We've been discussing the P/E, the most basic and one of the most valuable financial ratios. By relating price to a company's annual earnings per share, you can ignore some of the things that make stock pricing difficult. The P/E lets you ignore the whole issue of what a share of stock actually represents. Is it one one-millionth of the company or 3.584 ten-billionths of the company? You don't need to worry about that. The P/E focuses on the bottom line -- how much you are paying for a dollar's worth of corporate earnings.

As we saw on Friday, though, that price will be very different for different companies. So the next logical question is why would investors be willing to pay $67 for a dollar of Microsoft's <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> earnings but only $11 for a dollar of Caterpillar's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CAT)") else Response.Write("(NYSE: CAT)") end if %> earnings?

The most obvious answer is that Microsoft is growing its earnings much faster, which we discussed on Monday. But other factors are also at work -- mostly hard-to-quantify factors. For example: Brand recognition. Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %> is selling for a P/E of around 45 right now, while Pepsi <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> sells for about 30. Part of that difference is due to Coke's higher global brand recognition. How much? Don't ask me! (Brand recognition is important because of how it affects earnings, by the way; it's not a matter of the company being "popular.")

Another factor might be the quality of management. You may have noticed that stocks will often react to news of a CEO's departure or other management changes. This is part of the information that the great collective mind we refer to as Wall Street factors into its expectation of future earnings.

Other factors include how much debt the company is carrying (the payments on which will drain future earnings), how well the company can compete with others in its industry, and everything else, from interest rates to sunspots, that might conceivably affect the company's ability to earn money in the near-term future.

Theoretically at least, when all of this information is adjusted for, the P/Es of each company should be identical, and any discrepancies would signal the market's temporary under- or overpricing of that company. Estimating the impact of those factors is how fundamental stock analysis arrives at the intrinsic value of a share of stock.

Whew! Once again, isn't the Foolish Four strategy GREAT? Are we worried that the market dropped today? Heck, no! What counts is how these stocks do over the next 10 months, not what happened on any one day.

Fool on and prosper!

Today's Stock Lists | 1998 Dow Returns

02/24/99 Close
Stock  Change   Last
--------------------
CAT  -  15/16  46.00
JPM  -3 13/16  111.63
MMM  -1  5/8   76.19
IP   -   1/4   42.81

                   Day   Month    Year   History
        FOOL-4   -2.01%   4.30%   2.12%   3.63%
        DJIA     -1.52%   0.44%   2.53%   2.12%
        S&P 500  -1.40%  -2.05%   2.29%   2.53%
        NASDAQ   -1.56%  -6.64%   6.69%   8.15%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     46.00     6.78%
 12/24/98    9 JP Morgan    105.51    111.63     5.80%
 12/24/98   14 3M            73.57     76.19     3.56%
 12/24/98   22 Int'l Paper   43.55     42.81    -1.69%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1104.00    $70.00
 12/24/98    9 JP Morgan    949.62   1004.63    $55.01
 12/24/98   14 3M          1030.00   1066.63    $36.63
 12/24/98   22 Int'l Paper  958.12    941.88   -$16.25


                             Cash     $28.26
                            TOTAL   $4145.39

</FOOLISH FOUR PORTFOLIO>