One Up on Wall Street: How to Use What You Already Know to Make Money In

by Peter Lynch

  What you’re asking here is what makes a company valuable, and why it will be more valuable tomorrow than it is today. There are many theories, but to me, it always comes down to earnings and assets. Especially earnings. Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investors begin to doubt that will ever happen. But value always wins out—or at least in enough cases that it’s worthwhile to believe it.

  Analyzing a company’s stock on the basis of earnings and assets is no different from analyzing a local laundromat, drugstore, or apartment building that you might want to buy. Although it’s easy to forget sometimes, a share of stock is not a lottery ticket. It’s part ownership of a business.

  Here’s another way of thinking about earnings and assets. If you were a stock, your earnings and assets would determine how much an investor would be willing to pay for a percentage of your action. Evaluating yourself as you might evaluate General Motors is an instructive exercise, and it helps you get the hang of this phase of the investigation.

  The assets would include all your real estate, cars, furniture, clothes, rugs, boats, tools, jewelry, golf clubs, and everything else that would go in a giant garage sale, if you decided to liquidate yourself and go out of business. Of course you’d have to subtract all outstanding mortgages, liens, car loans, other loans from banks, relatives, or neighbors, unpaid bills, IOUs, poker debts, and so forth. The result would be your positive bottom line, or book value, or net economic worth as a tangible asset. (Or if the result is negative, then you’re a human candidate for Chapter 11.)

  As long as you’re not liquidated and sold off to the creditors, you also represent the other kind of value: the capacity to earn income. Over your working life you may bring home either thousands, hundreds of thousands, or millions of dollars, depending on how much they pay you and how hard you work. Here again, there are huge differences in cumulative results.

  Now that you’re thinking about it, you might want to put yourself in one of the six categories of stocks we’ve already gone over. This could be a halfway decent party game:

  People who work in secure jobs that pay low salaries and modest raises are slow growers, the human equivalents of the electric utilities such as American Electric Power. Librarians, schoolteachers, and policemen are slow growers.

  People who command good salaries and get predictable raises, such as the middle-level managers of corporations, are stalwarts: the Coca-Colas and Ralston Purinas of the work force.

  Farmers, hotel and resort employees, jai alai players, summer-camp operators, and Christmas tree sales-lot operators who make all their money in short bursts and then try to budget it through long, unprofitable stretches are cyclicals. Writers and actors may also be cyclicals, but the possibility of sudden increases in fortune makes them potential fast growers.

  Ne’er-do-wells, trust-fund men and women, squires, bon vivants, and others, who live off family fortunes but contribute nothing from their own labor are asset plays, the gold-mining stocks and railroads of our analogy. The issue with asset plays is always what will be left after all the debts are run up, and the creditors at the liquor store and the travel agency paid off.

  Guttersnipes, drifters, down-and-outers, bankrupts, workers who’ve been laid off, and others in the unemployment lines are all potential turnarounds, as long as there’s any energy and enterprise left in them.

  Actors, inventors, real estate developers, small businessmen, athletes, musicians, and criminals are all potential fast growers. In this group there’s a higher failure rate than there is among stalwarts, but if and when a fast grower succeeds, he or she may boost income tenfold, twentyfold, or even a hundredfold overnight, making him or her the human equivalent of Taco Bell or Stop & Shop.

  When you buy a stock in a fast-growing company, you’re really betting on its chances to earn more money in the future. Consider the decision to invest in a young Dunkin’ Donuts such as Harrison Ford, as opposed to a Coca-Cola type such as a corporate lawyer. Investing in the Coca-Cola type seems a lot more sensible while Harrison Ford is working as an itinerant carpenter in Los Angeles, but look what happens to earnings when Mr. Ford makes a hit movie such as Star Wars.

  The storefront lawyer isn’t likely to become a tenbagger overnight unless he wins a big divorce case, but the guy who scrapes barnacles off boats and writes novels might be the next Hemingway. (Read the books before you invest!) That’s why investors seek out promising fast growers and bid the stocks up, even when the companies are earning nothing at present—or when the earnings are paltry as compared to the price per share.

  You can see the importance of earnings on any chart that has an earnings line running alongside the stock price. Books of stock charts are available from most brokerage firms, and it’s instructive to flip through them. On chart after chart the two lines will move in tandem, or if the stock price strays away from the earnings line, sooner or later it will come back to the earnings.

  People may wonder what the Japanese are doing and what the Koreans are doing, but ultimately the earnings will decide the fate of a stock. People may bet on the hourly wiggles in the market, but it’s the earnings that waggle the wiggles, long term. Now and then you’ll find an exception, but if you examine the charts of stocks you own, you’ll likely see the relationship I’m describing.

  During the last decade we’ve seen recessions and inflation, oil prices going up and oil prices going down, and all along, these stocks have followed earnings. Look at the chart of Dow Chemical. When earnings are up the stock is up. That’s what happened during the period from 1971 to 1975 and again from 1985 through 1988. In between, from 1975 through 1985, earnings were erratic and so was the stock price.

  Look at Avon, a stock that jumped from $3 in 1958 to $140 in 1972 as earnings continued to rise. Optimism abounded, and the stock price became inflated relative to earnings. Then, in 1973, the fantasy ended. The stock price collapsed because earnings collapsed, and you could have seen it coming. Forbes magazine warned us all in a cover article ten months before the collapse began.

  And how about Masco Corporation, which developed the single-handle ball faucet, and as a result enjoyed thirty consecutive years of up earnings through war and peace, inflation and recession, with the earnings rising 800-fold and the stock rising 1,300-fold between 1958 and 1987? It’s probably the greatest stock in the history of capitalism. What would you expect from a company that started out with the wonderfully ridiculous name of Masco Screw Products? As long as the earnings continued to increase, there was nothing to stop it.

  Look at Shoney’s, a restaurant chain that has had 116 consecutive quarters (twenty-nine years) of higher revenues—a record few companies could match. Sure enough, the stock price has steadily moved up. In those few spots where the price got ahead of the earnings, it promptly fell back to reality, as you can see in the chart.

  The chart for Marriott, another great growth stock, tells the same story. And look at The Limited. When earnings stumbled in the late seventies, so did the stock. When earnings then soared, the stock soared as well. But when the stock got way ahead of earnings, as it did in 1983 and again in 1987, the result was a short-term disaster. The same was true for countless other stocks in the October, 1987 market decline.

  (A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies—such as Shoney’s, The Limited, or Marriott—when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well. [It sure would have worked with Avon!] I’m not necessarily advocating this practice, but I can think of worse strategies.)

  THE FAMOUS P/E RATIO

  Any serious discussion of earnings involves the price/earnings ratio—also known as the p/e ratio, the price-earnings multiple, or simply, the multiple. This ratio is a numerical shorthand for the relationship between the stock price and
the earnings of the company. The p/e ratio for each stock is listed in the daily stock tables of most major newspapers, as shown here.

  THE WALL STREET JOURNAL TUESDAY, SEPTEMBER 13, 1988

  73

  52 Weeks

  Yld P-E Sales

  Net

  High

  Low

  Stock

  Div.

  %

  Ratio

  100s

  High

  Low

  Close

  Chg.

  43¼

  21⅝

  K mart

  1.32

  3.8

  10

  4696

  35⅛

  34½

  35

  +⅜

  Like the earnings line, the p/e ratio is often a useful measure of whether any stock is overpriced, fairly priced, or underpriced relative to a company’s money-making potential.

  (In a few cases the p/e ratio listed in the newspaper may be abnormally high, often because a company has written off some long-term losses against the current short-term earnings, thus “punishing” those earnings. If the p/e seems out of line, you can ask your broker to provide you with an explanation.)

  In today’s Wall Street Journal, for instance, I see that K mart has a p/e ratio of 10. This was derived by taking the current price of the stock ($35 a share) and dividing it by the company’s earnings for the prior 12 months or fiscal year (in this case, $3.50 a share). The $35 divided by the $3.50 results in the p/e of 10.

  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. Let’s say you buy 100 shares of K mart for $3,500. Current earnings are $3.50 per share, so your 100 shares will earn $350 in one year, and the original investment of $3,500 will be earned back in ten years. However, you don’t have to go through this exercise because the p/e ratio of 10 tells you it’s ten years.

  If you buy shares in a company selling at two times earnings (a p/e of 2), you will earn back your initial investment in two years, but in a company selling at 40 times earnings (a p/e of 40) it would take forty years to accomplish the same thing. Cher might be a great-grandmother by then. With all the low p/e opportunities around, why then would anybody buy a stock with a high p/e? Because they’re looking for Harrison Ford at the lumber yard. Corporate earnings do not stay constant any more than human earnings do.

  The fact that some stocks have p/e’s of 40 and others have p/e’s of 3 tells you that investors are willing to take substantial gambles on the improved future earnings of some companies, while they’re quite skeptical about the future of others. Look in the newspaper and you’ll be amazed at the range of p/e’s that you see.

  You’ll also find that the p/e levels tend to be lowest for the slow growers and highest for the fast growers, with the cyclicals vacillating in between. That’s as it should be, if you follow the logic of the discussion above. An average p/e for a utility (7 to 9 these days) will be lower than the average p/e for a stalwart (10 to 14 these days), and that in turn will be lower than the average p/e of a fast grower (14–20). Some bargain hunters believe in buying any and all stocks with low p/e’s, but that strategy makes no sense to me. We shouldn’t compare apples to oranges. What’s a bargain p/e for a Dow Chemical isn’t necessarily the same as a bargain p/e for a Wal-Mart.

  MORE ON THE P/E

  A full discussion of p/e ratios of various industries and different types of companies would take an entire book that nobody would want to read. It’s silly to get bogged down in p/e’s, but you don’t want to ignore them. Once again, your broker may be your best source for p/e analysis. You might begin by asking whether the p/e ratios of various stocks you own are low, high, or average, relative to the industry norms. Sometimes you’ll hear things like “this company is selling at a discount to the industry”—meaning that its p/e is at a bargain level.

  A broker can also give you the historical record of a company’s p/e—and the same information can be found on the S&P reports also available from the brokerage firm. Before you buy a stock, you might want to track its p/e ratio back through several years to get a sense of its normal levels. (New companies, of course, haven’t been around long enough to have such records.)

  If you buy Coca-Cola, for instance, it’s useful to know whether what you’re paying for the earnings is in line with what others have paid for the earnings in the past. The p/e ratio can tell you that.

  (The Value Line Investment Survey, available in most large libraries and also from most brokers, is another good source for p/e histories. In fact, Value Line is a good source for all the pertinent data that amateur investors need to know. It’s the next best thing to having your own private securities analyst.)

  If you remember nothing else about p/e ratios, remember to avoid stocks with excessively high ones. You’ll save yourself a lot of grief and a lot of money if you do. With few exceptions, an extremely high p/e ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse.

  A company with a high p/e must have incredible earnings growth to justify the high price that’s been put on the stock. In 1972, McDonald’s was the same great company it had always been, but the stock was bid up to $75 a share, which gave it a p/e of 50. There was no way that McDonald’s could live up to those expectations, and the stock price fell from $75 to $25, sending the p/e back to a more realistic 13. There wasn’t anything wrong with McDonald’s. It was simply overpriced at $75 in 1972.

  And if McDonald’s was overpriced, look at what happened to Ross Perot’s company, Electronic Data Systems (EDS), a hot stock in the late 1960s. I couldn’t believe it when I saw a brokerage report on the company. This company had a p/e of 500! It would take five centuries to make back your investment in EDS if the earnings stayed constant. Not only that, but the analyst who wrote the report was suggesting that the p/e was conservative, because EDS ought to have a p/e of 1,000.

  If you had invested in a company with a p/e of 1,000 when King Arthur roamed England, and the earnings stayed constant, you’d just be breaking even today.

  I wish I had saved this report and had it framed for my office wall, to put alongside one that was sent to me from another brokerage firm that read: “Due to the recent bankruptcy, we’re removing this stock from our buy list.”

  In the years that followed, EDS the company performed very well. The earnings and sales grew dramatically, and everything it did was a whopping success. EDS the stock is another story. The price declined from $40 to $3 in 1974, not because there was anything amiss at headquarters, but because the stock was the most overpriced of any I’ve ever seen before or since. You often hear about companies whose future performance is “discounted” in the stock price. If that’s the case, then EDS investors were discounting the Hereafter. More on EDS later.

  When Avon Products sold for $140 a share, it had an extremely high p/e ratio of 64—though nowhere near as extreme as EDS’s. The important thing here is that Avon was a huge company. It’s a miracle for even a small company to expand enough to justify a p/e of 64, but for a company the size of Avon, which already had over a billion in sales, it would have had to sell megabillions worth of cosmetics and lotions. In fact, somebody calculated that for Avon to justify a 64 p/e it would have to earn more than the steel industry, the oil industry, and the State of California combined. That was the best-case scenario. But how many lotions and bottles of cologne can you sell? As it was, Avon’s earnings didn’t grow at all. They declined, and the stock price promptly plummeted to $18⅝ in 1974.

  The same thing happened at Polaroid. This was another solid company, with 32 years of prosperity behind it, but it lost 89 percent of its value in 18 months. The stock sold for $143 in 1973 and dropped to $14⅛ in 1974, only to bounce up to $60 in 1978 and then stumble once again, back to $19 in 1981. At the market high in 1973, Polaroid’s p
/e was 50. It got that high because investors expected an incredible growth spurt from the new SX-70 camera, but the camera and the film were overpriced, there were operating problems, and people lost interest in it.

  Again, the expectations were so unrealistic that even if the SX-70 had succeeded, Polaroid would probably have had to sell four of them to every family in America to earn enough money to justify the high p/e. The camera as a rousing success wouldn’t have done much for the stock. As it was, the camera was only a moderate success, so it was bad news all around.

  THE P/E OF THE MARKET

  Company p/e ratios do not exist in a vacuum. The stock market as a whole has its own collective p/e ratio, which is a good indicator of whether the market at large is overvalued or undervalued. I know I’ve already advised you to ignore the market, but when you find that a few stocks are selling at inflated prices relative to earnings, it’s likely that most stocks are selling at inflated prices relative to earnings. That’s what happened before the big drop in 1973–74, and once again (although not to the same extent) before the big drop of 1987.

  During the five years of the latest bull market, from 1982 to 1987, you could see the market’s overall p/e ratio creep gradually higher, from about 8 to 16. This meant that investors in 1987 were willing to pay twice what they paid in 1982 for the same corporate earnings—which should have been a warning that most stocks were overvalued.

  Interest rates have a large effect on the prevailing p/e ratios, since investors pay more for stocks when interest rates are low and bonds are less attractive. But interest rates aside, the incredible optimism that develops in bull markets can drive p/e ratios to ridiculous levels, as it did in the cases of EDS, Avon, and Polaroid. In that period, the fast growers commanded p/e ratios that belonged somewhere in Wonderland, the slow growers were commanding p/e ratios normally reserved for fast growers, and the p/e of the market itself hit a peak of 20 in 1971.