Editor's note: Each week, one of our investing experts answers a reader's question in a Q&A column at our sister site, InvestingAnswers.com. It's all part of our mission to help consumers build and protect their wealth through education. This week's question is answered by David Sterman.
Answer: New investors can be overwhelmed by all of the acronyms and catch phrases.
Yet with a little grounding in key concepts, it's easy to grasp their meaning and learn how to profit from them.
Perhaps the most popular acronym is EPS, and its related acronym, P/E or the price-to-earnings ratio. EPS stands for earnings per share; it's a company's net profits divided by the number of shares outstanding. A company with $30 million in net profits and 60 million shares outstanding has EPS of 50 cents (30/60=0.5).
Of course, on its face, EPS tells us little. We want to know how that figure compares to a company's stock price. That's why investors calculate the P/E, which is EPS divided by a stock price. In this example, a $10 stock price yields a P/E ratio of 20 (10/0.5=20).
Is 20 a good number? We first want to compare that P/E with a company's earnings growth rate. We also want to compare it with the ratios sported by rival companies. And we want to see how that figure compares with historical values.
Let's take a closer look.
Investors like to find companies with growing EPS. And they want that earnings growth rate to be higher than the P/E ratio. So using the example above, a company that is boosting profits at a 25% annual pace and has a P/E ratio of 20 is generally considered a good value.
But what if a rival has a P/E of just 10? Isn't that stock more appealing as it has a lower P/E ratio? Not necessarily. Again, we want to see how fast EPS is growing. If that rival's earnings are barely growing, then even a P/E of 10 may seem too high.
This all leads to the same question that most investors have: What is the right P/E for a company that is boosting EPS at a steady 10% annual pace?
Here's where it gets tricky.
Nearly a decade ago, Microsoft (and the broader technology sector) was in high-growth mode. From fiscal 2006 (which began in June) through fiscal 2010, Microsoft's EPS grew at a 16% annual pace, so investors were comfortable buying shares as long as the company's P/E was in the mid-teens, or lower than the earnings growth rate.
But in recent years, Microsoft's EPS growth has slowed to a crawl. As a result, the P/E (based on projected fiscal 2013 profits) is just 10. Until Microsoft can generate more rapid EPS growth, the P/E ratio is unlikely to rise, which means it will only appreciate in value at the rate that profits are growing -- which isn't very much.
Now let's look at Ford, which is a deeply cyclical business.
Cyclical businesses such as Ford tend to boom and bust, depending on whether the economy is growing or shrinking. The deep economic slowdown of 2008 was so scary that Ford's stock briefly moved below $2.
These days, Ford's stock has rebounded as sales and profit growth resume. Ford made roughly $1.40 in EPS in 2012, though analysts think EPS will exceed $2 by the middle of the decade. Right now, Ford's stock would appear to be a bargain, as it has a P/E ratio of just 6.5 times those projected mid-decade profits, especially since Ford's EPS is expected to grow at a double-digit pace in coming years.
The key to owning these cyclical stocks is getting them when they are on the cusp of a robust earnings rebound. Yet history has also shown that it is wise to sell them when EPS moves back up to peak levels, as the next move is likely downward.
One final note: Once you've grasped the nature of EPS, the P/E ratio and the earnings growth rate, you should start looking at other financial measures.
For example, if you are comparing Ford and General Motors (NYSE: GM), you'll want to see which company has the stronger balance sheet, which company has the more promising pipeline of new vehicles heading to showrooms, and which company is poised to pay a higher dividend or be more aggressive with share buybacks.
In short, EPS and the P/E ratio are a great starting point, but they're not the ultimate determinant of what makes a stock appealing.