Multiples, and what they mean
Imagine you’re researching PomPoms.com (ticker: RAHHH), an online cheerleading supply firm, and you read that “it deserves to trade at 24 times earnings, or about $56 today.” You’re flummoxed. The concepts involved are simple and valuable, though, so let’s clear them up.
The word “multiple” usually refers to a company’s price-to-earnings, or P/E, ratio, which is its current stock price divided by its last 12 months of earnings per share. A company trading at $40 per share with an EPS of $2 has a P/E of 20. It is trading at “20 times earnings,” or at “a multiple of 20.”
It can be helpful to compare a company’s multiple with what seems to be a fair multiple, given its industry and competitive position. Let’s say that PomPoms.com’s peers all have multiples in the high 20s and its own multiple is in the mid-teens. A low multiple can be promising, suggesting that the stock is undervalued and that the price will increase as the multiple catches up to its peers. (It can also indicate a firm that’s losing in the marketplace, though.)
Also auspicious are briskly growing earnings. Earnings growth drives stock price growth. Rapid growth can sometimes justify a relatively high multiple. How fast earnings grow is also a good indicator of how high a company’s P/E should be.
Ask the Fool
Q: If I sell a stock for a loss in my IRA account, can I deduct that loss on my personal tax return? — B.Y., Lawrence, Kan.
A: Nope. You typically deposit pre-tax money into a traditional IRA. Eventually, you’ll be taxed on your entire withdrawals from it, regardless of any gains or losses. (Of course, if you make non-deductible contributions to your traditional IRA, they won’t be taxed when you take them in the form of distributions.) With Roth IRAs, you invest post-tax money and eventually withdraw it all tax-free. But you don’t claim losses (or pay taxes on gains) in the interim.
My dumbest investment
I recognized the recent stock bubble before it burst and moved my cash from stocks to real estate. But a close friend, seeing his $80,000 in two stocks approach $500,000 and keep rising, kept pressuring me to buy. I researched them and wasn’t impressed (one was WorldCom). I ultimately bought one, at $21, simply to keep my friend — but I lost my shirt. The shares started falling, and I stupidly purchased some more. My friend was ecstatic that I was now going to be “rich” like him. The shares fell further, to 1 cent apiece, with bankruptcy looming. So much for a $100,000 investment for a friend — who has gone from being an almost-multimillionaire to being broke. Don’t ever buy stock to please someone else just because he is a friend. — George Conrad, via e-mail
The Fool Responds: Friends may mean well, but they’re not necessarily great investors. Trust your gut and your research.