Securities can be analyzed in several different ways. This chapter covers the following analytical methods:
Price to earnings (PE) ratios help investors judge whether a company’s stock may be overvalued or undervalued. The price is the company’s market price per share. The earnings are the company’s profits on a per-share basis (earnings per share). Earnings are reported on a corporate income statement.
A higher PE ratio often suggests the stock is priced high relative to its current earnings. For example, a PE ratio of 100 means the market price is 100 times the company’s annual earnings per share. Unless profits are expected to grow substantially, the stock may be overpriced. On average, PE ratios often fall in the 15-25 range, depending on the company and industry.
Growth companies typically have higher PE ratios. These businesses are expanding and are expected to generate higher profits in the future. As a result, the stock may look “expensive” today, but investors may still consider it attractive if they expect strong long-term growth.
For example, Roku stock (symbol: ROKU) reflected a PE ratio of 180 as of October 2021. That means the stock price was 180 times the company’s annual earnings per share. If you bought the entire company and earnings stayed the same, it would take 180 years to earn back the purchase price through profits. Investors accept a PE ratio this high only if they believe profits will rise significantly.
Value companies typically have lower PE ratios. These businesses are often large, established firms with a long history of profits. Because investors usually don’t expect dramatic growth from mature companies, they’re generally less willing to pay a high multiple of current earnings.
For example, Allstate stock (symbol: ALL) reflected a PE ratio of 6 as of October 2021. That means the stock price was 6 times the company’s annual earnings per share. If you bought the entire company and profits stayed the same, it would take about 6 years to recoup the purchase price through profits. Compared with Roku, Allstate appears much cheaper.
Because value companies usually don’t grow as quickly, value stocks often don’t produce large capital gains. So where does the return come from? Many value companies pay cash dividends. Allstate is an example; it has consistently paid quarterly dividends to shareholders.
There are several ways to estimate a company’s value. Book value uses accounting measures - especially assets and liabilities - to estimate what the company is worth. There are multiple ways to calculate book value, but the details aren’t important for the exam. In general, you can think of book value as the company’s value from an accountant’s perspective.
The price to book ratio compares a company’s stock price to its book value. You’re unlikely to be asked to calculate it, but here’s the formula:
The higher the stock price is relative to book value, the higher the price-to-book ratio. High price-to-book ratios may indicate a company is overvalued. For example, if an accountant estimates a company is worth $2 million (book value), but the market values it at $100 million (market price), the price-to-book ratio would be 50. For reference, most stocks don’t exceed a ratio of 5:1, and the average ratio in the S&P 500 is roughly 3.
The lower the stock price is relative to book value, the lower the price-to-book ratio. Low price-to-book ratios may indicate a company is undervalued. For example, if book value is $2 million but the market price is $1 million, the price-to-book ratio would be 0.5, well below the S&P 500 average of about 3.
After a corporation pays its cost of goods sold, operating expenses, interest and principal on outstanding debts, and taxes, it has net earnings (profits). To see how this works, here’s the sample income statement from the fundamental analysis chapter:
| Line item | Amount |
|---|---|
| Sales revenue | +$200,000 |
| Cost of goods sold (COGS) | -$80,000 |
| Gross profit | $120,000 |
| Operating expenses | -$30,000 |
| Income from operations (EBIT)* | $90,000 |
| Interest (bonds & loans) | -$25,000 |
| Income before taxes (EBT)* | $65,000 |
| Taxes | -$10,000 |
| Net income | $55,000 |
*EBIT = earnings before interest & taxes
*EBT = earnings before taxes
In this example, the corporation has $55,000 of net income (net earnings). When profits exist, a corporation can use them in one of three ways:
Growth companies often retain profits so they have capital to expand. Value companies, which tend to be larger and consistently profitable, often distribute part of their profits as cash dividends and retain the rest for future business needs. It’s rare for a company to distribute 100% of its earnings.
Because of this, investors often want to know a company’s dividend payout ratio. Here’s the formula:
Using the same income statement, we can add two lines to show dividends and retained earnings:
| Line item | Amount |
|---|---|
| Sales revenue | +$200,000 |
| Cost of goods sold (COGS) | -$80,000 |
| Gross profit | $120,000 |
| Operating expenses | -$30,000 |
| Income from operations (EBIT)* | $90,000 |
| Interest (bonds & loans) | -$25,000 |
| Income before taxes (EBT)* | $65,000 |
| Taxes | -$10,000 |
| Net income | $55,000 |
| Dividends paid | -$20,000 |
| Retained earnings | $35,000 |
*EBIT = earnings before interest & taxes
*EBT = earnings before taxes
Can you calculate the dividend payout ratio?
Answer = 36.4%
To calculate the dividend payout ratio, you need two items: net income and dividends paid. The corporation reported $55,000 in net income and paid $20,000 in dividends.
You may also see this calculation using per-share figures. Here’s an example:
An investor is researching a stock and performing several calculations to determine its quality. They find the following pieces of data:
- Quarterly dividend = $1.00
- EPS = $10.00
When the inputs are per share, the dividend payout ratio is typically written as:
Earnings per share (EPS) measures profitability on a per-share basis. For example, a company with $10,000,000 of net earnings and 1,000,000 shares outstanding would have EPS of $10.
Now return to the dividend payout ratio question:
An investor is researching a stock and performing several calculations to determine its quality. They find the following pieces of data:
- Quarterly dividend = $1.00
- EPS = $10.00
What is the stock’s dividend payout ratio?
Can you figure it out?
Answer = 40%
Watch the timing. Dividends are given quarterly, but the dividend payout ratio uses annual dividends. A $1.00 quarterly dividend equals $4.00 per year. EPS is already annual, so it stays $10.00.
In summary, the dividend payout ratio shows how much of a company’s profits are paid out to shareholders. Growth companies tend to have low payout ratios (or no payout ratio if they don’t pay dividends), while value companies often have higher payout ratios.
In the dividend models and discounted cash flow chapters, we introduced the time value of money. A dollar received today is worth more than a dollar received in the future because of opportunity cost. If you receive money later, you lose the chance to invest it and earn returns in the meantime.
For the rest of this chapter, the focus is on:
This section (Present value) is a repeat from the previous discounted cash flow chapter, but the NPV and IRR sections in this chapter are new. Regardless, you should re-read this section as the following sections build upon the example discussed below.
Present value tells you what a future amount of money is worth in today’s dollars.
Here’s what each part means:
Now work through an example:
An investor is considering the purchase of a $1,000 par, 2-year, 5% corporate debenture currently trading at 97. The rate of return in the market is 6%. What is the present value of the debenture?
Because this is a 2-year bond, there are two sets of cash flows to discount:
Present value - year 1
The bond pays a 5% coupon, based on its par value of $1,000. That means it pays $50 of annual interest. In year 1, the investor receives only this $50.
Interpreting the result: if the market return is 6%, then receiving $50 one year from now is equivalent to having $47.17 today and earning 6% for one year. The difference reflects the opportunity cost of waiting.
Present value - year 2
In year 2, the investor receives another $50 of interest and the $1,000 par value at maturity, for a total of $1,050.
Interpreting the result: receiving $1,050 two years from now is equivalent to having $934.50 today and earning 6% compounded for two years.
Putting it all together
Add the present values of the year 1 and year 2 cash flows:
From a time value of money perspective, the bond’s present value is $981.67. This gives you a benchmark to compare against the bond’s current market price.
Once you’ve calculated present value, compare it to the investment’s market value (its cost). That comparison is the net present value (NPV):
From the present value example above:
Now calculate NPV:
Because present value ($981.67) is higher than the market price ($970.00), the bond appears underpriced by $11.67 based on this discounted cash flow approach. A positive NPV suggests the investment is a “good deal” relative to the discount rate used. If you’re comparing multiple investments using discounted cash flow, the one with the highest positive NPV would be preferred.
A negative NPV suggests the opposite. Reset the numbers:
Now calculate NPV:
Here, the bond appears overpriced by $8.33 based on the same discounted cash flow approach.
One common point of confusion: NPV is not simply a measure of whether you’ll make money in absolute terms. Even with a negative NPV, the investor may still receive interest and principal and end with more dollars than they started with. NPV is best understood as a comparison to the market return used as the discount rate:
What if NPV is zero? That means the investment is appropriately priced* - its present value equals its market price. In return terms, a zero NPV implies the investment’s return matches the average market return (the discount rate).
*When an investment is appropriately priced, the market it trades in is efficient. The more efficient a market, the more its prices reflect true value. On the other hand, an inefficient market has over and/or underpriced investments, which would reflect positive and/or negative NPVs.
An investment’s internal rate of return (IRR) measures its overall rate of return. The word “internal” means the calculation focuses on the investment’s own cash flows rather than external forces (for example, inflation or other market risks). A common textbook definition is:
The IRR is the discount rate that results in the NPV of all future cash flows being equal to zero
This connects directly to what you just saw with NPV:
Return to the earlier example:
An investor is considering the purchase of a $1,000 par, 2-year, 5% corporate debenture currently trading at 97. The rate of return in the market is 6%.
We calculated the bond’s present value as $981.67. If the bond traded at exactly $981.67, NPV would be zero, and the bond’s IRR would be equal to the market return (6%).
Now compare that to different market prices:
Here’s the relationship in table form:
| NPV | IRR |
|---|---|
| Positive | Greater than average market return |
| Zero | Equal to average market return |
| Negative | Lower than average market return |
A bond’s IRR is equal to its yield to maturity (YTM). YTM is the bond’s overall rate of return if held to maturity. Test questions may use IRR and YTM interchangeably.
Present value, NPV, and IRR work best when future cash flows are predictable. Bonds are a good fit because they pay fixed interest and return par value at maturity, so the future cash flows are known.
These tools are less useful when future cash flows are uncertain. That’s why present value, NPV, and IRR calculations are not typically associated with securities like common stock*. Many common stocks pay no cash dividends, and even dividend-paying companies may raise, suspend, or cancel dividends.
*While present value, NPV, and IRR calculations are not typically utilized for common stock due to its unpredictable future cash flow, it can be used for preferred stock. As a reminder, preferred stock pays a fixed, predictable dividend rate.
Bottom line: time value of money calculations are most appropriate when future cash flow is predictable. As cash flows become less predictable, present value, NPV, and IRR become less relevant and less accurate.
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