How Should You Measure a Stock’s Value?

Price-to-earnings (P/E) ratio has long been a standard measure of a stock’s value – but there are more ways than one to measure it.

Are you using the most appropriate measure?

P/E ratio is a company’s current stock price divided by its annual earnings per share.

For example, a stock trading at $40 per share with earnings per share of $2 would have a P/E ratio of 20 ($40 divided by $2).

A stock priced at $20 per share with earnings per share of $1 would also have a P/E ratio of 20 ($20 divided by $1).

P/E ratio is effective in expressing how much investors are paying for the value a company creates.

The problem is, there are more ways than one way to calculate P/E ratio, and all have their flaws.

Trailing P/E ratio, for example, is based on known earnings over the past year.

So, if a company’s past year’s earnings were unsustainably high, today’s P/E ratio might be deceivingly low.

On the other hand, another P/E ratio measure uses earnings forecasts, which may change in response to economic conditions.

Another trick used when calculating P/E ratio is to use so-called operating earnings instead of earnings as defined by regulators – and there’s no legal definition for operating earnings.

That said, stocks still appear cheap, at least by trailing P/E ratios, as of late September 2011.

At that time, at least 81 large U.S. companies had single-digit P/E ratios, according to Thomson Reuters.

In general, investing in stocks with low P/E ratios, whatever the measure used, may be a good idea because P/E ratios show what investors are prepared to pay for every $1 of a company’s earnings – and this, in turn, reflects the stock market’s view of the outlook for the company.

Time to Tweak Your Portfolio as 2011 Ends?

Smart investors understand the importance of rebalancing their portfolios by bringing their mix of stocks, bonds, cash and other assets back in line on a regular basis – even when markets threaten that orderly mix on a daily basis.

And what better time to rebalance than year-end?

The idea behind rebalancing is simple. If you never do so, over the long term, your better-performing investments will make up an ever-growing piece of your portfolio – and because these investments are likely those with higher risk, such as stocks, you could end up with a more aggressive allocation than you initially wanted.

When the markets are volatile, you may think you need to rebalance more often than usual, but that’s probably not the case. Why? Large moves in the market don’t necessarily lead to large moves in a portfolio.

For example, in a portfolio with 60% allocated to stocks and 40% allocated to bonds, a 5% drop in the stock market would still leave almost 59% of the portfolio in stocks. To push the portfolio five percentage points off its target, stocks would have to decline by 19%.

Instead of chasing daily market movements, consider rebalancing on some kind of schedule.

But don’t do that more than once a month.

And only do it when allocations stray more than, say, five percentage points from their targets.

Your financial advisor can help you decide what’s appropriate given your risk tolerance.