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402-Using Ratios and Multiples2

  Price/Earnings Growth (PEG)
  As an offshoot of the P/E ratio, PEG is calculated by dividing a company's P/E
  by its growth rate. PEG is extremely popular with some investors because it
  seeks to relate the P/E to a piece of fundamental information--a company's
  growth rate. On the surface, this makes sense because a firm that is growing
  faster will be worth more in the future (all else being equal).
  
  PEG = (Forward P/E Ratio) / (5-Year EPS Growth Rate)
  
  The problem with PEG is that risk and growth often go hand in
  glove--fast-growing firms tend to be riskier than average. This conflation of
  risk and growth is why PEG is frequently misused. When you use a PEG ratio
  alone to compare companies, you're basically assuming that all growth is
  equal, generated with the same amount of capital and the same amount of risk.
  
  However, firms that are able to generate growth with less capital should be
  more valuable, as should firms that take on less risk. If you look at a stock
  that is expected to grow at 15% trading at 15 times earnings and another one
  that is expected to grow at 15% trading at 25 times earnings, don't just plunk
  your money down on the former because it has a lower PEG ratio. Look at the
  capital that each firm needs to invest to generate the expected growth, as
  well as the likelihood that those expectations will actually materialize, and
  you might very well wind up making a very different decision. But still, what
  PEG does give you is a quick and easy way to estimate the price you're paying
  for future growth.
  
  
  Yield-Based Valuation Models
  In addition to ratio-based measures, you can also use yield-based measures to
  value stocks. For example, if we invert the P/E and divide a firm's earnings
  per share by its market price, we get an earnings yield. If a stock sells for
  $40 per share and has $2 per share in earnings, then it has a P/E of 20 (40/2)
  but an earnings yield of 5% (2/40). Unlike P/Es, the nice thing about yields
  is that we can compare them with alternative investments, such as bonds, to
  see what kind of a return we can expect from each investment. One main
  difference, however, is that earnings generally grow over time, whereas bond
  payments are fixed.
  
  Let's put earnings yield into perspective. In early 2005, you could get a
  risk-free return from Uncle Sam of about 4.5% by buying a 10-year Treasury
  bond. Therefore, you would want to demand a higher rate of return from your
  stocks because they are riskier than Treasuries. A stock with a P/E of 20
  would have an earnings yield of 5%, which is a bit better than Treasuries, but
  perhaps not enough considering the additional risk you are taking. It all
  depends on whether the company will be able to grow its profits in the future
  to make accepting a 5% yield today worthwhile.
  
  Meanwhile, a stock with a P/E of 12 would have an earnings yield of 8.3%
  (1/12), which is much better than those poky Treasuries, even if earnings
  never grow. Thus, in this situation you might be induced to take on the
  additional risk of owning the stock.
  
  
  Dividend Yield
  Dividend yield is actually one of the oldest valuation methods. It was very
  popular back in the days when dividends were the primary reason people owned
  stocks, and it is still widely used today, mainly among income-oriented
  investors. Dividend yield is equal to a company's annual dividend per share
  divided by a stock's market price. For example, a company that pays an annual
  dividend of $1.00 per share and trades for $20 has a dividend yield of 5%
  (1/20). If that same stock's price rose to $40 a share, its dividend yield
  would fall to 2.5%--the more expensive the stock, the lower the yield.
  Dividend Yield = (Annual Dividends Per Share) / (Stock Price)
  
  As with all valuation ratios, dividend yield must be used with caution. Stocks
  with very high dividend yields might seem like bargains, but these companies
  are often going through financial problems that have caused their stock price
  to plunge. It's not unusual for companies in such situations to cut their
  dividend in order to save cash, so their actual dividend yield going forward
  might be lower than the currently reported figure. Lastly, one major drawback
  of dividend yield is that it is useless for companies that don't pay a
  dividend--a group that includes many technology stocks.
  
  
  Cash Return
  The best yield-based valuation measure is a relatively little-known metric
  called cash return. In many ways, it's actually a more useful tool than the
  P/E ratio. You can calculate cash return by adding free cash flow (cash from
  operations minus capital expenditures) to net interest expense (interest
  expense minus interest income), and then dividing the sum by enterprise value
  (market cap plus long-term debt, minus cash). We add back interest expense to
  free cash flow so that capital structure doesn't impact cash return.
  
  Cash Return = (Free Cash Flow Net Interest Expense) / (Enterprise Value)
  The goal of the cash return metric is to measure how efficiently the business
  is using its capital--both equity and debt--to generate free cash flow. In
  other words, cash return tells you how much free cash flow a company generates
  as a percentage of how much it would cost an investor to buy out the entire
  business.
  
  Let's use beverage giant Coca-Cola KO as an example of how to use cash return
  to find reasonably valued investments. In April 2005, Coke had a market cap of
  about $100 billion and carried $1.2 billion in long-term debt and $6.7 billion
  in cash on its balance sheet. Its enterprise value was $100.0 $1.2 - $6.7,
  or $94.5 billion. That gives us the first part of our ratio. The other half is
  free cash flow, adjusted for interest expense. In 2004, Coke generated about
  $5.3 billion in adjusted free cash flow. Thus, our cash return on Coca-Cola
  will be $5.3 billion/$94.5 billion, or 5.6%.
  
  With 10-year Treasuries yielding just 4.5% and corporate bonds yielding a
  higher (but still relatively paltry) 5.1% in April 2005, that 5.6% cash return
  for Coke looks pretty good. Throw in the fact that Coke's free cash flow is
  likely to grow over time, whereas those bond payments are fixed, and Coke in
  April 2005 starts to look like a pretty solid value.
  
  Cash return is a great first step to finding cash cows trading at reasonable
  prices, but avoid using cash return for financials or foreign stocks. Cash
  flow is not terribly meaningful for banks and other firms that earn money via
  their balance sheets. And because definitions of cash flow can vary widely in
  other countries, a foreign stock that looks cheap based on its cash return may
  simply be defining cash flow more liberally.
  
  
  The Bottom Line
  Even if you end up using the more thorough valuation methods highlighted in
  the next lessons, it will be highly likely you will use the ratios highlighted
  in this lesson when discussing stock valuation with other investors. Just
  remember the limitations of each of these ratios, and keep in mind the context
  of every situation.