When smart investors go looking for stocks, they do not focus on the price of the stock. A stock that is trading for $100 a share can easily be a better deal than a stock trading for $10 a share.
Rather than focus on price, clever investors focus on valuation – specifically, the relative valuation of a stock’s price compared to how much cash it produces for the investor. Focusing on this approach can help investors to narrow the universe of attractive stocks from hundreds, or thousands, to a more manageable number.
Price-to-Earnings Ratio as a Valuation Metric
The most commonly used metric for relative valuation is the price-to-earnings ratio, or P/E ratio. Essentially, the P/E ratio is simply the price of a stock by its earnings per share. There are some small variations here – many investors use the last 12 months of GAAP earnings, while others will focus on earnings from the last calendar year, or on non-GAAP earnings. Regardless of the specifics, the P/E ratio is a widely used – though imperfect – tool for evaluating stock investments.
More on that in a moment though.
First, it helps to understand how to calculate a P/E. Let’s pretend we have two firms: Company A and Company B. Company A has a price of $40, and Company B has a price of $20. Which one is the better investment? The answer depends on their earnings (among other factors).
If Company A has earnings per share of $4, then its P/E ratio is $40/$4 or 10X. If Company B has earnings per share of $1, then its P/E ratio is 20X ($20/$1). In this case, relative valuation would suggest that Company A offers a better opportunity as it costs less to generate a profit of $1, all else being equal.
Yet there are issues with the P/E ratio that should make investors cautious. In particular, three problems often come up when dealing with P/E ratios:
- Earnings can be manipulated – companies can and do manipulate their earnings (within the bounds of the law) to help manage their stock price.
- Earnings are volatile – many companies go through cyclical swings where business is very good or very bad, and thus using a simple P/E ratio can lead to temporarily high or low relative valuations.
- Earnings matter less to investors than cash flows – many companies have artificially high or low accounting profits, but that’s not what investors care about. Instead, investors focus on cash flows, a factor unaccounted for by the P/E ratio.
Learn more about other investing ideas here.
Merits of Using Price-to-Dividend Ratio as a Valuation Metric
An alternative to the P/E ratio is to use a metric that accounts for cash flows, and one good option is to compute the Price to Dividend Per Share ratio, or P/DPS ratio.
P/DPS ratios are easy to calculate just like P/E ratios. Let’s take Companies A and B again. Company A had a share price of $40, while Company B had a price of $20. Let us assume that both the companies pay a dividend of $0.50. In this scenario, the P/DPS ratio for Company A is 80X ($40/$0.50), while for Company B it is 40X ($20/$0.50). In this situation, an investor might conclude that Company B is the better option because it costs less upfront to receive $1 of ongoing dividends from the firm.
Investors can easily use the screener on Dividend.com to select securities that meet certain criteria. The dividend screener can help to research sectors and industries offering attractive dividend yields and investors can research more than 15 parameters, as well as download data for their own custom analysis.
P/DPS ratios offer investors a number of key advantages. For one thing, P/DPS as a ratio is more trustworthy as cash is actually being paid out, thus the company is actually making money. Many firms have essentially phantom earnings – earnings are generated on an accounting basis, but shareholders never see a dime. Using a P/DPS ratio removes that issue.
In addition, this metric is less volatile for companies that are regular dividend payers. Companies tend to be loath to cut their dividend, and in fact there are many companies that have been paying consistent or increasing dividends for a decade or more to investors. Nevertheless, a decrease or suspension of dividends is usually perceived negatively by investors as it might indicate some fundamental problems with the company.
Finally, companies that pay attractive dividends out to investors tend to have lower price volatility. A company that can safely pay a $1 per share dividend to investors has a floor under its price that a non-dividend paying firm lacks. Dividends ensure that shareholders always get some return, which in turn helps to bolster the stock price.
The Bottom Line
Overall, the P/E ratio is a widely used metric, but it is not as useful or effective as the P/DPS ratio. Investors might start by using a simple P/E ratio, but it generally makes sense to go beyond that before investing.
For investors who want to use the P/DPS metric for their investment decisions, Dividend.com can be a great place to start. Ticker pages for firms like Apple (AAPL ) show the stock’s current price at the top of the page, and then the annualized dividend payout and dividend yield under the heading ‘Stock Dividend Data’ part of the way down the page. In addition, you can separately view and download historical dividend payouts for any stock on Dividend.com. For this you can click on ‘Dividend History’ and ‘Payout History’ tabs located just below the share price on any ticker page.
So the next time you are considering a company as an investment, use the ticker pages to find the stock price and the DPS. Doing so can help you to make better investment decisions.
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