Peter Lynch: How to Invest Like a Pro (rare clip)
The price of a stock will follow the direction of earnings in almost every case. You can generally state if a company's earnings go up sharply, the stock's going to go up. If earnings go from very poor to mediocre, the stock's probably going to rise. If they go from mediocre to good, it's probably gonna have another rise. If it goes from good to excellent, it's probably gonna have another rise. Or, if a company's earnings grow dramatically over a long period of time, the stock's probably gonna go up dramatically.
Even if you have a Waterford crystal ball, you probably can't predict a company's earnings. But Wall Street is a whole army of people who make such predictions by computer. You can get Wall Street earnings estimates in the research section of the stock shop or through many other online services. Or you can go to your local library and find earnings estimates in Value Line or Standard and Poor's. Obviously, you want to invest in companies whose earnings are expected to rise.
But again, these are just estimates. If you really understand a company, you should know how it plans to make earnings rise. If you know it has good growth prospects, then you'll be better able to evaluate the company as an investment. You can't predict the future, but you can learn from the past. A company with a long history of earnings increases and dividend increases is obviously a stable performer that has a reasonable chance of continuing to perform well in the industry. Many times, that's a good company to investigate further.
Johnson & Johnson has raised its earnings something like 19% in the last 20 years; it's raised its dividend over 30 years in a row. But just because a company has had a great record in the past does not mean earnings will grow terrifically well in the future. You have to have reasons for it: strong growth, research and development, cost-cutting, new products, a great brand name, and a terrific balance sheet were the items that made me optimistic about Johnson & Johnson.
And what's the outlook? That's going to keep continuing to grow. They run out of steam; stocks going to run out of steam. Price-earnings ratio is something that some people make very complex; it's actually very simple. If a company is selling a hundred dollars a share and earning ten dollars, it's a price-earnings multiple of ten. The P/E ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investment, assuming, of course, that the company's earnings stay constant.
Why look at P/E? It can tell you if you're paying too much for a stock. The higher the P/E, the more expensive the stock relative to the company's future earning power. The lower the P/E, the cheaper the stock. I use a rule of thumb to level out these differences: a fairly priced stock is a P/E that's about equal to the expected annual growth rate over the next three to five years. If the P/E is substantially higher than the growth rate, the stock is normally expensive. If the P/E is substantially lower, the stock is probably cheap.
A stock's P/E in part depends on the industry it's in. When you look at a growth company, compare the company's growth rate and its own P/E to that of the industry. All things being equal, if you find a company with a much lower P/E and a higher growth rate, you're off to a good start. You can also compare a company's P/E to its own historical P/E. If a company normally sells for 25 times earnings and now it's selling at 15 or less, you have to ask yourself why.
The company could be maturing; competition may be entering the field, and its growth prospects may be uncertain. But maybe it's simply been beaten down by some other factors, and it's possibly a bargain—it's worth researching. Back in the 1970s, Electronic Data Systems, or EDS, had a P/E of 500 times earnings. If you had invested in a company with a P/E this high when Columbus discovered America, the company's earnings had stayed constant; you'd just be breaking even today.
In 1974, EDS performed very well, but the stock fell from 40 to 3 simply because the stock was so grossly overpriced relative to current earnings. Dividends are cash payments that companies make to shareholders, usually every quarter. Nearly half the return of the S&P 500 over the past 50 years has come from dividends. Dividends come from profits. If a company earns five dollars a share, they have the choice of paying out some of it to the shareholders in the form of a cash dividend.
A stock's yield is the annual dividend payout divided by its current price. The yield is the return you get on your investment every year. One drawback: the IRS considers dividends as income, so you have to pay taxes on dividends. Not all companies pay a dividend; fast growers, for example, almost never pay a dividend. They reinvest all of their earnings back into the company. Slow growers tend to pay out profits and dividends; it's their way of rewarding shareholders.
Over time, those dividends can add up. Some people have bought stocks for five dollars a share, and twenty years later they're getting ten dollars a share of dividends per year. Dividends do make a difference. They are a great way to measure company success, particularly a slow-growing company. When a company raises its dividend every year, it raises the bar for its financial performance in the years that follow. Few companies want to cut their dividends; investors clobber the stock, figuring a dividend cut is a sign of worse things to come.
So by raising a dividend 12% to 15% this year, the company is saying it expects earnings to be at least as good next year as they are now and probably rising by at least the 12% to 15%. You can get a list of companies that have raised their dividends many years in a row from Moody's. There are some great names in this list. However, you can find warning signs of dividends as well. A high yield isn't always a good thing. If a stock is 30 and it's paying a three-dollar dividend, you might say, “Wow, that's terrific, a ten percent yield.”
But if the earnings are only three dollars and ten cents a share, then the company is essentially paying out all of its earnings in dividends. That's only 10 cents to expand or to invest in more efficient equipment. If this continues for a number of quarters or years, the company will have very little room for any errors or setbacks. Eventually, the company will probably cut back or totally suspend its dividend; the stock price is going to tumble with it. Be careful with high-yield stocks, particularly when they're paying out a very high percentage of their earnings.
Any company's operations can hit an air pocket from time to time. You've got to make sure your company can survive tough times. The balance sheet tells you about the company's financial structure: how much debt it has, how much cash it has, and how much equity its shareholders have. There's nothing scary about a balance sheet. No story is complete without a check of the balance sheet.
The basic concept of a balance sheet is that everything a company owns, its assets, are listed on one side. On the other side, you find everything a company owes, its liabilities. The difference between what it owns and what it owes is its equity, also called its net worth. Go ahead and explore this fictional balance sheet; click any of the items on this balance sheet for an explanation of it. When you're ready to move on, click either the debt or cash buttons for a discussion of the two most important items on any balance sheet.
Does the company have a lot of cash on hand? That's great—a company with a lot of cash can buy more stock, make an acquisition, or pay off all its debt; all moves that shareholders love to see. A company should have at least enough cash to pay off its short-term debt. If it doesn't, it could have to keep borrowing more and more. If you subtract cash from short-term debt and long-term debt, and the total is only one quarter of net worth, the company has a decent balance sheet.
However, if short-term debt and long-term debt combined, minus cash, equals or exceeds net worth, the company has a weak balance sheet. It's simple to recognize a strong balance sheet: no debt and lots of cash. Suppose a company has 20 million dollars in cash after subtracting all debt. If the company has four million shares outstanding, it has five dollars of cash per share of stock. If you buy the company at ten dollars a share, you're paying only five dollars for the company, and you're getting five dollars a share in cash—that's a really amazing price.
In effect, that means your real price is five. If this company has a very solid predictable business, this extra cash is quite valuable. But if a company has lots of cash and they're losing money, you still have to value it. How quickly will they run through all that cash? That's all you really have to know. It's not much, but you should know it. You can look it up in the stock shop. If you don't check your company's survivability, you're not only skimping on your research; you're gambling. That's not why you invest in the stock market.
Check the debt. Most companies have some, but how much is too much? Add up the company's long-term debt and total equity; that's a good approximation of the company's total capitalization, the money the company has available to grow its business in the future. Now compare the long-term debt to total capitalization. If total debt equals half of the company's capitalization or more, beware. That's quite a bit of debt to service.
That much debt means everything has to work right; things don't always work just right. If debt equals twenty percent of capitalization or less, that's better. That's fairly low debt. As usual, there's no rule without some exceptions. Debt in some industries, like banking, insurance, and financial services, routinely runs much higher than twenty to fifty percent. Know the industry and what is normal for it when you evaluate a balance sheet.
In many industries, such as retailing and restaurants, companies have leases—they have commitments on buildings to rent for a long period of time. Often, this form of debt will only appear in the footnotes. This is a very substantial form of debt. Look into the footnotes; see if you see capitalized lease obligations. Add this back; this is an important exercise.