Profitability Ratios

Return on Equity

Return on equity (ROE) is the best way to learn how much money a company is making for its investors. It is calculated by dividing the company's net profit by shareholder's equity. It is represented mathematically (in percentage terms) as follows:

ROE = Net Profit *100/Equity

ROE can reveal how much the company is making compared with how much it has invested to make that. Just to use a simple example, if you invest $100 in a rare baseball card and sell it for $120, your net profit will be $20 ($120 - $100 = $20), and your ROE would be $20/$100 or 20%. The $100 in the denominator is your equity in the card business.

The latest available ROE figures at the time of this writing for Microsoft Corporation, PepsiCo, and Motorola, were approximately 28.4%, 29.8%, and 5%.

When looking at a company, it is important to look at the trend in ROE to make sure that it is not steadily declining. Seasoned investors sometimes look at the ROE of other companies in the same industry to make sure that the ROE of the company they are looking at is in line with its competitors.

Earnings per Share

Earnings per share , or EPS, is the amount of money the company actually earns for each share of stock that is outstanding. It is calculated, in percentage terms, as follows:

EPS = Net Profit*100/(#Of Common Shares Outstanding)

EPS should increase each year. As discussed earlier, companies report their earnings for each quarter-in other words, every three months. Just before companies announce their earnings to the world, investment analysts make predictions about the amount of money these companies will make for each share of stock outstanding for the current quarter and for the year (or years) to come. This information can give you a good idea what the best minds on Wall Street think about certain companies.

Wall Street analysts publish their best EPS estimates for big, publicly traded companies. When these companies finally report their earnings, most investors usually compare the Wall Street analysts' projections with the companies' actual earnings per share for the quarter. If the actual EPS is less than the Wall Street analysts' projections, the stock price of the company usually goes down. The opposite can also happen.

We recommend that Teenvestors ignore analysts' earnings projections for the current quarter and focus on long-term projections and the reasons why those projections were made. What should matter to you is what the analysts feel the stock will do in the next year or two. See if their logic makes sense to you; invest for the future, not the present.

Price-Earnings Ratio

The price-earnings ratio , or PE (also known as PE ratio), is one of those topics that we have to discuss, not because it is so important to Teenvestors, but because a lot of other investors focus on it. The PE is one way investors use to determine how much a stock costs compared with how much the company earns. The PE is today's price of the stock divided by the amount of money per share made by the company over the past year. Mathematically, it is calculated as follows:

PE Ratio = Today's Price Per Share/EPS

Like most of the data in this section, PE can be found in a number of good financial websites. The way to interpret PE is that it tells you how many years it will take for you to get back your investment if you buy one share of a company's stock (and all of the company's net profit each year gets distributed as dividends). By way of example, suppose you buy a share of Teenvestor Inc. at $30 and the yearly EPS (earnings per share) is $2. T

his means that the first year after buying the stock, you would earn $2. You'd earn another $2 for the second year; and another $2 for the third year. If we keep going, you will see that it will take 15 years to earn back a total of $30-your initial investment. You could have figured out how long it will take to earn back the $30 investment by dividing the stock price by the earnings per share ($30/$2 = 15).

Investors refer to stock as either cheap or expensive based on PE levels. For a given stock, a PE of, say, 20 is more expensive than a PE of 15. Some investors believe that, over a long period of time, the PE of companies stays stable, so they watch PEs to see when it is cheap for them to buy the stock. For example, if the PE ratio of Teenvestor Incorporated has been 50 for the past 10 years, and is suddenly 30, these types of investors will buy more of Teenvestor Incorporated's stock in hopes that the PE ratio will move back up to 50, meaning that the stock price may go back up.

But one major flaw of focusing on PE ratios is that PE can increase even if the stock price does not go up. If EPS goes down, the PE ratio can go up. What this means is that if you buy Teenvestor Incorporated's stock when it has a PE ratio of 30, and it later goes to a PE ratio of 50, it would not necessarily mean that the company's stock price went up. It could mean that earnings per share went down.

Growth stocks (or companies whose earnings grow by 10-20% per year for about 5 years or more) usually have high PE ratios. PE ratios are typically high for technology and Internet companies if they make money at all. For example, at the height of the Internet boom in 2000, the PE ratio for eBay, the online auction house, was over 2300.

This high level of PE is not really meaningful to an investor since the only reason it was so big was because eBay was making very little money at that time. In other words, eBay's tiny earnings at that time, which is used in the denominator of the PE formula (Price Per Share/Earnings Per Share) made the ratio very big. To drive the point home, what will be the PE ratio of a company that has no earnings? Mathematically, when you divide any stock price by 0 (which represents no earnings), you will get an infinite number.

Of course, an infinite PE ratio is meaningless. For new industries (such as the industries created from the Internet), you can't use the PE ratio as a measure of whether companies are cheap or expensive until these companies have steady earnings over a 3 to 5-year period. And even then, using PE ratio to spot bargains is flawed.