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P/E ratio just part of equation

It's not stock price alone that investors need to pay attention to, writes CAROLINE ALPHONSO

Pop quiz: Berkshire Hathaway Inc.'s Class A shares are quoted at $73,800 (U.S.). Philip Morris Cos. Inc. stock changes hands for $42. Which shares are relatively more expensive?

If you said Berkshire Hathaway because its paper costs more, you're missing the bigger picture.

With Berkshire Hathaway -- the conglomerate run by billionaire Warren Buffett -- investors get a chance to dip their toes in the company's three dozen or so holdings from Fruit of the Loom to Dairy Queen. Meanwhile, tobacco and consumer product company Philip Morris and others in its industry are suffering from litigation and shrinking revenues.

It's not the stock price alone that investors need to pay attention to, but what they get for their money in the form of assets, management and cash flow.

Investors frequently look at the earnings multiple before putting money into a stock in order to assess whether it is cheap or expensive relative to other similar stocks, or to historical values. Essentially, this is the price-to-earnings ratio, calculated by dividing the stock's current price by the company's earnings per share. It shows how much investors are willing to pay per dollar of earnings, and it is also used in determining if a company is overvalued or undervalued.

Berkshire's stock, for example, trades at about 30 times estimated 2002 earnings, while Philip Morris trades at around nine times. While one looks overvalued and the other undervalued, it's important look at other factors as well -- Berkshire offers its investors more and carries less risk.

If a company's sales grow and if it regularly increases its dividend, the earnings multiple typically moves higher, because investors are willing to bet more on the company. But if the risk profile increases for a company, such as those in the tobacco industry and its legal problems, this multiple falls because investors are not willing to pay as much for the stock.

While the investment community has long considered earnings multiples to be useful measures for assessing relative value, many market watchers believe investors put too much of an emphasis on earnings multiples.

"It's not that I think they do. I know they do. Markets are obsessed with earnings multiples," said Ramy Elitzur, a finance professor at the University of Toronto. "Investors are functionally fixated."

There are many pitfalls to using earnings multiples, as many investors have found out recently. Ten years ago, many stood by them. But now, the bursting of the tech bubble and the market downturn, along with accounting scandals, have thrown out of whack what investors have come to expect as "normal" multiples.

One of the problems with this price-to-earnings ratio is the denominator. Earnings are an accounting figure, and the guidelines for accounting rules vary in each country. Also, earnings per share can be twisted into various numbers depending on how companies do their books. The result? Investors don't know if they are comparing the same figures over time and among a range of companies, or apples with oranges.

When Irwin Michael, president of I.A. Michael Investment Counsel Ltd., is looking at a company, he doesn't only examine the price-to-earnings multiples.

He takes a closer look at the company's management and the statements they have made about the health of their firm or the industry. At the same time, bad management could also make for a good investment in a company, he said, because it leaves the company ripe for an acquisition.

Mr. Michael also looks for hidden assets. This can be time-consuming, but Mr. Michael said that by looking through a company's financial notes, investors can uncover real estate, stock-option plans or even over-funded pension funds.

"We look for things that are not commonly known," he said. "I look at the back where they can't colour it too much."

Another item to look for is a company's products and services. "You don't want to buy into a company that's producing buggy whips," he said. Mr. Michael tends to shy away from high-tech companies, saying "what's high tech today is low tech tomorrow."

Finally, Mr. Michael looks for what he calls "value catalysts." These could include anything from fresh management with new directions to an important sale or purchase of a meaningful asset. "You need a spin -- something that is going to turn on the markets," he said.

"There's more than just P/E multiples."

Instead of looking at a company earnings, many market watchers suggest looking at a company's cash flow. Mr. Elitzur said cash flow is more factual. "One could repeat the message 'cash is king,' " he said.

Neeraj Monga, an analyst with Veritas Investment Research, said earnings are just numbers that management reports, while cash determines what is available to shareholders. He pointed to companies, such as networking giant Cisco Systems Inc. and oil and gas firm EnCana Corp., that not only have real earnings, but free cash flow. This is a measurement of a company's profitability after all expenses and reinvestments.

Mr. Monga said investors should trust conservative companies with sound management. He looks for companies that invest in their businesses -- as long as that investment is coming from the internal generation of cash and the company is not taking on additional debt.

This may be a lot for the average investor to digest.

"It's pretty complex," said Bill Procter, a fund manager at Mackenzie Financial Corp. "It comes down to honesty and management crediblity."

As a final check before investing in companies, Mr. Procter looks at the price-to-earnings multiple. He prefers to focus on free cash flow. "For us, it works better," he said.

In the end, however, most analysts agree that a company that doesn't give investors anything out of their investment, such as dividends, is not worth that much. Buying into concepts can prove to be a gamble. While innovation and growth is important, it should be left to those who understand it best.

Mr. Monga puts it best: "If you go to a restaurant and you don't like the food there, why would you eat it? It's the same thing with investing. If you don't understand the company, why would you buy the stock?"
Price/earnings ratios
What is a p/e ratio?
A p/e ratio shows how much investors are willing to pay per dollar of earnings. It is a much better indicator of the value of stock than the stock price alone.
The ratio is calculated by dividing the stock's price by the company's annual earnings per share.
Can I trust a p/e ratio?
A p/e ratio only accounts for the price of a stock relative to the earnings of that company. The ratio does not reflect the quality of management, debt, assets or growth potential, other key considerations in a stock's value.
For example, a stable company with a reliable revenue stream, good growth prospects and regular dividend payments would be considered relatively undervalued if it had the same p/e ratio as a company in a more volatile sales environment with uncertain growth prospects and no dividend.

© The Globe and Mail

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