Look beyond company’s share price

Ever look at a stock’s price and think, “$10 per share — that looks like a cheap price”? Or “$75 per share? No thanks. That’s too steep for me.” If so, snap out of it!

Never look at two stocks trading at similar prices and think that they represent similar values. For example, consider Target and Wal-Mart. At the time of this writing, each company’s stock was trading in the mid-$40s per share.

Look at market capitalization, the total value of all outstanding shares, which serves as an approximate price tag for a company. (It’s calculated by multiplying outstanding shares by current share price.) Target’s market cap is around $40 billion. That’s very big, but Wal-Mart’s market cap is roughly $185 billion. The market is attributing more than four times as much value to Wal-Mart as to Target.

Here’s another pair: Home Depot and Lowe’s. Both recently had stock trading not too far from $30 per share. A closer look, though, reveals that Lowe’s is a $45 billion company, and Home Depot a $73 billion one. Lowe’s sales have been growing at about 18 percent per year for the past five years, vs. Home Depot’s 12 percent rate. Both firms sport similar net profit margins, around 7 percent, but while the Lowe’s dividend yield is about 0.50 percent, Home Depot’s is three times as high, near 1.5 percent.

Companies with low prices might be overvalued, while those with high prices could be bargains. The price-to-earnings (P/E) ratio is just one of many valuation measures, but let’s apply it to some firms. Financial giant Citigroup was recently trading around $48 per share, which may seem high, but its P/E was just 10. Meanwhile, Microsoft had a share price of just $24, with a P/E of 20.

Price alone is meaningless. To get a real sense of a company’s attractiveness, you need to examine many measures and compare them.

To see how we evaluate companies, try our Motley Fool Inside Value newsletter for free at www.fool.com/shop/newsletters. You’ll be able to see a long list of stocks we think are undervalued.

Purchase Perceptions

Q: If a company is bought by another company, will the acquired company’s stock price go up or down? – S.W., Statesboro, Ga.

A: It depends on the purchase price. If the firm’s current market value is around $1 billion and it’s bought for $1.5 billion, you can expect the stock price to leap up on the news. When a company is very desirable, perhaps because of its products or growth prospects, a buyer may have to outbid other interested companies. But if a firm is struggling, perhaps faced with losses and significant debt, it might get scooped up for a song.

Q: What’s a moving average? — P.D., Mansfield, Ohio

A: Imagine a table that details the annual return of a mutual fund for 20 years. The numbers will probably fluctuate quite a bit — perhaps down 4 percent one year, up 12 percent another. One way to smooth them out a bit, while still getting a sense of how they may be changing, is to calculate moving (also called rolling) averages. For three-year moving averages, you’ll first average the returns for years 1, 2 and 3. Then you’ll average years 2, 3 and 4. Then years 3, 4 and 5, and so on, ending with years 18, 19 and 20.

My dumbest investment

Yep, I bought Pillowtex. I figured that the textile maker had already been through one bankruptcy, so how could it possibly go down a second time? It did, though, filing for Chapter 11 bankruptcy protection in 2003. Pillowtex was traded on the OTCBB (over-the-counter bulletin board), so I learned to avoid companies trading on the OTCBB — particularly those trading for less than a dollar a share! — S.J.C., Tucson, Ariz.

The Fool Responds: Many textile makers in America have gone out of business, including Pillowtex, which was more than 100 years old. You learned a good lesson, to be wary of OTCBB stocks. They’re generally trading there because they’ve been de-listed from a major exchange (such as the New York Stock Exchange or the Nasdaq), or because they don’t qualify to trade on the larger exchanges. Another lesson is to pay attention to an industry’s conditions. In textiles, for example, companies face stiff international competition that cranks out inexpensive wares made by low-paid workers. You’ll find more promising pastures elsewhere.