Chapter 1

Stock Market Basics: Earnings

 

When looking at stock market basics, there is no sense in reading a word about growth stocks until you have learned the fundamentals of general stock market investing. In this chapter, I will quickly survey the basic methods of stock measurement and evaluation.

Basic Measuring Standards

Of the many measuring devices used by security analysts to gauge the value of a stock, the grice-earnings ratio is by far the most popular. In the last analysis, shares are part of business ownership and the purpose of business is to make money. If a company fails to earn money, its other assets, such as ground and machinery, are of little use. That's why investors pay less and less attention to things like the "book value" of a stock, and place more and more weight on earning power. It's the earning power that really counts!

Book value is obtained by adding the company's assets and dividing the sum by the number of common shares outstanding to get book value per share. Book value excludes such intangibles as management., patents, research and new product development though they are important in shaping the market price of a stock.

A General Method of Determining Stock Prices

Price-earnings ratio is a much more realistic standard of measurement. Since every business is out to make money, it seems only logical to determine the price of a stock on the basis of the amount of money the company is able to learn, The general practice is to price a stock on the basis of a company's latest twelve-month earnings multiplied by a figure which varies _de-pending on the market appraisal of a. particular situation. Some stocks are evaluated as low as 4 or even 3 times earnings, while others as high as 30, 40, 50 or even more times.

The 425 industrial stocks composing the Standard & Poor index are selling at an average of 19 or so times their latest twelvemonth earnings. The more the market values a certain stock, the higher it places its multiplier, and vice versa.

If you have some idea about the kind of multiplier the market is likely to accord a certain stock, you should be able to get into the situation at a profitable level. The question is, of course, how?

When looking at stock market basics, generally speaking, the 19 or so times earnings for Standard & Poor's industrial stocks is undoubtedly high, compared with 12 to 15 times earnings for the inflationary period of 1954-57. Historically, the average ranged from a low of 7.4 in October 1906 to a high of 21.5 in May 1960. Some conservative-minded investors shudder at anything that violates the traditional rule of thumb that holds a stork should sell at approximately 10 times annual earnings

To the majority of today's investors, however, this traditional standard of measurement is a yardstick of bygone days. To them, it is as outdated as old-time companies whose high-failure rate made stockholders insist on an annual yield of 6 per cent for their risk. In order for a company to pay a 6 per cent dividend, it had to earn 10 per cent—hence the 10-times-earnings yardstick. This was, of course, before unemployment compensation, before the Employment Act of 1946 and before many other welfare economies of the Roosevelt and Truman administrations. The nation's economic structure changed long ago. The vastly changed fundamental environment apparently accounts for the average investor's willingness to buy many stocks at prices which are considered high by the traditional standard.

A Look at Comparative Evaluations of Industry Groups

How can we, as small investors, figure out the proper price-earnings ratios for stocks in which we are interested? To begin with, we should know something about the comparative status of various stock groups or industry classifications. If, for instance, you know that chemical stocks are generally given multipliers of 20 to 30, then the first step is to determine the status of the company in question as a basis for allotting it a place between the lower limit of 20 and the upper limit of 30. Or, for another instance, if aircraft stocks are generally accorded 10 to 17 times earnings, then securities of this classification should be evaluated accordingly, unless some exceptionally well-situated issues should deserve higher multipliers due, say, to their heavy engagement in electronics or outer-space exploration.

The Langley Value Digest

When looking at stoc market basics, a good place to get information on how different industry groups are faring in price-earnings ratios is W. G. Langley & Co.'s extremely valuable Digest of Price-Earnings Ratios of Leading Industrial, Utility and Railroad Common Stocks. The Digest, published periodically, gives you horizontally comparative evaluation ratios of various industry groups and vertically tells you whether a particular industry is going forward or backward or standing still in the market evaluation.

Here, we reproduce the industry classification and price-earnings-ratio columns of two Langley digests separated by six months:

Price-Earnings Ratio

Aircraft Manufacturing                                      5-1-61             11-1-61
Boeing                                                              13.6                 12.6
North American Aviation                                  16.4                 15.2
Price-Earnings Ratio

Air Transport                                                    5-1-61             11-1-61
American Airlines                                             17.4                 21.1
United Air Lines                                               16.6                 11.1

Automobiles
Chrysler                                                           —                    —
Ford Motor                                                      10.5                 14.3
General Motors                                                15.7                 18.3

Building
Johns-Manville                                                 23.4                 21.8
Minneapolis-Honeywell                                    42.4                 37.6
National Lead                                                   22·9                 22.1
Pittsburgh Plate Glass                                       18.3                 20.9
U. S. Gypsum                                                   23.0                 23.0

Chain Stores
Great Atlantic & Pac. Tea                                 19.8                 24.3
Penney (J. C.)                                                  22.0                 28.2
Sears Roebuck                                                 23.5                 32.2

Chemicals
Allied Chemical                                                25.0                 24.9
American Cyanamid                                         22·l                  21.1
Dow Chemical                                                  30.4                 34.1
duPont (E. I.) de Nemours                                26.4                 29.0
Monsanto Chemical                                          19.1                 22.6
Union Carbide                                                  27.2                 26.8

Containers
American Can                                                  19.2                 18.5
Continental Can                                                17.4                 17.0
Owens-Illinois Glass                                         22.5                 22.2

Drugs
American Home Products                                 32.9                 37.6
Merck                                                              35.5                 32.6
Parke Davis                                                      21.1                 23.8
Pfizer (Charles)                                                 25.8                 27.2

Electrical Products
General Electric                                                28.6                 36.3
Radio Corp. of America                                   32.4                 30.7
Westinghouse Electric                                       20.8                 33.9

Finance
C. I. T. Financial                                               16.7                 19.3
Commercial Credit                                           14.8                 18.0
Price-Earnings Ratio
                                                                        5-1-61             11-1-61
Food Products
Borden                                                             23.8                 25.6
Campbell Soup                                                 25.7                 31.1
Corn Products                                                  26.8                 31.1
General Foods                                                  29.2                 35.1
General Mills                                                    18.6                 20.2
National Biscuit                                                20.0                 21.1
National Dairy Products                                    18.5                 22.3

Machinery (Farm & Indust.)
Caterpillar Tractor                                            19.5                 19.0
Deere & Co.                                                    21.0                 11.3
Ingersoll-Rand                                                  19.6                 20.7
International Harvester                                      22.0                 17.5

Metals
Aluminium Ltd.                                                 29.8                 25.7
Aluminum Co. of America                                 46.2                 33.1
American Smelting & Ref.                                 20.6                 21.6
Anaconda Co.                                                  14.2                 11.3
International Nickel                                           26.8                 31.4
Kaiser Aluminum & Chemical                           46.3                 28.4
Kennecott Copper                                            13.1                 14.2
Phelps Dodge                                                   14.6                 15.0
Reynolds Metals                                               38.8                 30.8
Office Equipment
International Business Mach.                             72.2                 80.1
National Cash Register                                     35.9                 42.2

Oil
Cities Service                                                   13.5                 12.5
Continental Oil                                                  20.1                 17.2
Gulf Oil                                                            12-1                 12.1
Phillips Petroleum                                             17.7                 16.8
Royal Dutch Petroleum                                     10.4                 8.5
Shell Oil                                                           18.0                 16.5
Sinclair Oil                                                        12.0                 12.8
Socony Mobil Oil                                             11.7                 11.0
Standard Oi] of California                                 12.8                 11.8
Standard Oil of Indiana                                     13.6                 11.4
Standard Oil of New Jersey                              14.3                 13.1
Texaco                                                             16.0                 15.1

Paper
Crown Zellerbach                                             20.7                 22.8
International Paper                                            18.4                 21.3
Kimberly-Clark                                                24.8                 24.6
Scott Paper                                                      31.4                 36.8
5-1-61                                                             11-1-61

Public Util.—Electric
American Electric Power                                  26.9                 29.7
Central & South West                                      27.6                 30.1
Commonwealth Edison                                     19.6                 23.2
Consol. Edison of New York                            20.6                 22.8
Consumers Power                                            20.2                 21.9
Florida Power & Light                                      30.8                 37.1
Middle South Utilities                                        23.5                 26.6
Niagara Mohawk Power                                  19.2                 19.8
Pacific Gas & Electric                                       18.6                 21.7
Southern California Edison                                15.3                 20.2
Southern Co.                                                    29.0                 30.0
Texas Utilities                                                   32.3                 34.0

Public Utilities—Gas
American Natural Gas                                      18.2                 20.2
Consol. Natural Gas                                         17.6                 22.6
Northern Natural Gas                                       18.7                 19.0
Panhandle Eastern Pipe Line                             13.6                 14.6
United Gas                                                       15.3                 15.8

Railroads
Atchison Topeka & Santa Fe                            14.9                 14.9
Norfolk & Western                                          14.2                 14.5
Southern Pacific                                                10.6                 11.9
Southern Railway                                              13.5                 14.5
Union Pacific                                                    12.0                 12.5

Steel & Iron
Armco Steel                                                     20.2                 19.5
Bethlehem Steel                                                30.1                 22.2
Inland Steel                                                      23.2                 17.6
Republic Steel                                                  33.7                 24.4
U. S. Steel                                                        24.0                 23.7

Tire & Rubber
Firestone Tire & Rubber                                   17.5                 20.2
Goodrich (B. F.)                                               21.4                 22.4
Goodyear Tire & Rubber                                  20.0                 20.2
U. S. Rubber                                                    16.6                 15.7

Miscellaneous
American Tel. & Tel                                         21.9                 22.0
American Tobacco                                           17.1                 20.1
Corning Glass Works                                       55.4                 49.1
Eastman Kodak                                                33.6                 34.2
Minnesota Mining & Mfg.                                 59.4                 51.4
Procter & Gamble                                            31.1                 35.9

Stocks of every industry group have been appraised and will be reappraised on the basis of changed or changing circumstances. The supergrowth status of oil shares has all but vanished. Both uranium and airline stocks have their days of growth behind them. As for the steel and automobile industries, they seem to be in trouble because of industry overcapacity. More and more investors have cast doubt over the growth prospects of the chemical industry because of its growing idleness and narrowing profit margins.

Current Earnings vs. Potential Earnings

By accepted standards, price-earnings ratio has generally been based on the latest available twelve-month earnings, though it has become an increasing practice to figure the ratio on the basis of future earnings. When people talk about price-earnings ratios, be sure whether they are talking about current earnings or poten-tial earnings. Also, more and more security analysts have favored projecting earnings into the future. Instead of talking about earnings for the current fiscal year, they talk about earnings for some future year. That, of course, makes a lot of difference. For a stock selling at 50 times current earnings of $1 per share would be selling at only 25 times projected earnings of $2, say, three years from now.

Another increasing practice in figuring earnings is doing so in terms of annual earnings rate instead of actual annual earnings. For instance, if a company reported fourth-quarter earnings of 25¢ per share, it is said to be earning at an annual rate of $1 per share despite the fact that the company earned only a total of 25¢ in the previous three quarters (which would mean actual annual earnings of 50¢ per share). It might present a more accurate earning picture, though it could be highly misleading, if the earnings improvement during the fourth quarter were only seasonal instead of indicative of any future trend.

Something to remember when looking at stock market basics is that just as there is no substitute for money in the bank, so there is no substitute for actual earnings. Projected or estimated earnings are the old saw's "two in the bush." Be a little suspicious of anything that has yet to he realized, especially a thing of the distant future. Anything can happen during long intervals.

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