It should only take you 60 seconds to understand the key fundamentals of a publicly traded company.
Let's work with an example, like Apple Inc. on December 9, 2017.
First, look at their market cap. It's 870 billion dollars (USD). That's how much money you need to buy 100% of Apple if all outstanding shares were available for sale at their current market price ($169.37). The market cap immediately tells you what fraction of Apple you get to own for each dollar that you invest into buying its stock. You don't even need to look at the number of outstanding shares because that's already built into the market cap (though you should if you want a truly accurate value for ownership percentage per share).
Dollar Cost of Buying Apple Stock:
- 100% - 870B
- 10% - 87B
- 1% - 8.7B
- 0.1% (one of a thousand pieces) - 870M
- 0.0001% (one of a million pieces) - 870K
- 0.0000001% (one of a billion pieces) - 870
It should be clear that if you buy 5 shares of Apple stock ($846.85), you own a fraction of the company equivalent to one of a billion pieces. This is the reality behind the price you pay for the ownership you get.
Now that you know exactly what you can get, it's time to reason whether or not the price is right. Move onto the earnings per share (EPS). EPS is just annual profit divided by the number of outstanding shares. But EPS can be calculated in different ways.
You absolutely must pay attention to what kind of EPS you are looking at. Is it based on the last 12 months? Apple's last 4 quarters (Q4 2016 to Q3 2017) total an EPS of $9.21 per share. Is it based on the last reported quarter multiplied by 4? For Q3 2017, Apple reported a quarterly EPS of $2.07 per share, which multiplies by 4 into $8.28 per share. Is it based on analyst estimates for the next 4 quarters (Q4 2017 to Q3 2018)?
The EPS is important because it is where shareholders make money from. Historically, Apple has distributed between 25% and 30% of their net earnings to shareholders. To keep things simple and optimistic let's suppose that Apple uses a dividend payout ratio of 30% into the future.
Recall the trailing 12-month EPS of $9.21. As a simple calculation, 30% of that is $3.07. This means that if Apple maintains its current profit level for the foreseeable future, shareholders will receive dividends of $3.07 per year for each share they own. Given the current stock price ($169.37), that is a mediocre yield of 1.8%.
But that is because Apple is currently reinvesting over 70% of their net earnings to grow the business in terms of revenue and profit. If Apple decides that it no longer sees room to grow, they may reduce their reinvestment ratio from 70% to the value required just to maintain their market share and profit level. Suppose that maintenance ratio is 25%. Combining the new dividend payout ratio of 75% with the trailing EPS of $9.21 gives us a dividend of $6.91 per year. If you bought Apple shares at $169.37 each, your new annual yield would be an acceptable but weak 4.1%.
For Apple to reach a dividend yield of 8% at their growth-oriented payout ratio (30%), they would have to increase their profits by over 340%. To reach a dividend yield of 8% at their maintenance-only payout ratio (est. 75%), they would have to increase their profits by over 90%.
Recall Apple's market cap of about $870B. Such as large market cap makes it difficult for the company to improve earnings for investors because it takes so much profit growth in absolute terms to cause EPS growth in percentage terms. If you buy 5 shares of Apple at the current market price, you would have a combined attributed earnings (trailing 12-month) of $46.05. For every dollar of attributed earnings growth in your 5-share portfolio, Apple would need to grow their profits by a billion dollars; assuming a constant profit margin of ~21%, revenue would need to grow by 5 billion dollars. To double the EPS and your attributed earnings from $46.05 to $92.10, growth would need to achieve an additional 46B in profits and additional 220B in revenue. It is crucial to connect the percentage EPS growth required for a decent return to the absolute revenue growth that is grounded in real customer purchases.
If you buy Apple stock at $169.37, you must understand that you are committing to fundamental expectations of not only company survival but also the yield characteristics described above.
Old Reference Style:
Market Cap: The market value of a company's outstanding shares.
Calculation: Multiply the current market price of the stock by the total outstanding shares of the company.
The market cap represents the size of a company. It also benchmarks a reasonable cost for acquiring the company through a 51% or greater buy-out.
The market cap determines the fraction of profits that an investor would be receiving. For instance, consider a company with a 1B (1000M) market cap. Given enough sellers at the current stock price, an investor could spend 1M to buy a thousandth (0.1%) of the company. The market cap is convenient because you can immediately tell what percentage of the company you would get for, say, 1000 dollars.
Then, suppose the company reports quarterly net earnings of 100M with a 50% dividend payout ratio; from the 50M in total dividends, the investor is obliged to 0.1% of that (50K). If this quarterly dividend continues, the investor gets an annual yield of 200K (20% on their 1M principal).
The market cap also indicates the degree to which the earnings growth of a company improves the yield of owning its stock. The larger the market cap, the more earnings a company needs for the same improvement on its rate of return. This is because you get less ownership of a high market cap company for the same amount of money.
Consider what it takes for a company to improve its dividend yield by 3%. A high market cap company may have to grow its profits by 10B. Conversely, a low market cap company may only have to grow its profits by 1M. The higher a company's market cap, the more diluted its earnings growth for a given investment amount.
Price-Earnings Ratio (P/E Ratio)
P/E Ratio: A measure of how expensive a company is, comparing its price per share to its earnings per share.
Calculation: Divide the current stock price by the annual earnings associated with a single share.
The P/E ratio is a convenient metric that hints at how much yield to expect from a stock when the company declares its next dividend payout. Consider a company with a stock price of 10 dollars and earnings per share of 2 dollars per year. This gives us a P/E ratio of 5. The meaning is simple. For every 5 dollars invested, you get 1 dollar of profit associated with your partial company ownership.
Although it is simple to determine that a P/E ratio of 5 suggests a dividend yield of 20%, the workings of price and profit do not guarantee you that exact return. First, profits are usually distributed at a payout ratio much below 100% (because the company needs to reinvest profits to pay off long-term debt and maintain or grow its market share). A typical payout ratio is around 30%. Second, the P/E ratio fluctuates. By purchasing stock, you lock in the price, but the earnings of the company may grow or falter as time passes. A low P/E ratio now may be misleading if the company is about to enter a downward earnings spiral. A high P/E now may be misleading if the company is about to grow its annual earnings really well. Ideally, you want to invest in a company with a low P/E ratio and high earnings growth.
The P/E ratio is calculated in different ways. The value for annual earnings per share is particularly varied, using historic, latest, and forecasted earnings. Variations are used because different companies have different revenue cycles and growth trajectories. In the end, what is important is to get a useful value that is accurate for the reported information thus far, which may include analyst projections. For example, the trailing P/E ratio uses the actual earnings per share generated by the company from the past 12 months. Alternatively, the forward P/E ratio uses the predicted earnings per share projected by analysts for the next 12 months. Another variation may combine trailing 6 months with forward 6 months. Another variation may just use the earnings per share from the latest quarterly report and multiply that by 4 to get an annual value.
Suppose that you buy a growth stock that has P/E ratio of 30 and does not currently issue dividends. By purchasing the stock now, you have locked in the price paid per share. Now suppose that after 5 years, the company matures and starts declaring dividends at a balanced payout ratio of 50%. Importantly, the company has grown its earnings such that your personal P/E ratio is 5 (using the price you paid years ago) even though the stock price has dramatically increased for a market P/E ratio of 40. While your P/E ratio of 5 would suggest a yield of 20%, the company's payout ratio of 50% makes it such that you actually get a 10% yield for this year. The following years may be a different story, depending on how the company's earnings grow or sink.
Consider how much profit growth is required to take a given purchase price to a decent P/E ratio, such as 10 for an effective dividend yield of 3% to 5%. Note that growth-stage companies are usually running on negative earnings per share. Use the market cap to extrapolate the required earnings per share growth into the required total earnings growth. After preparing the values for required earnings and current earnings, you can model various growth curves to figure out how many years of what percentage growth would get your investment to a good yield.
Desired earnings growth curves can be used to model revenue growth curves that can be further considered against the industry's total market size. Pay attention to your expectations for the maturation of the company's profit margin. Consider long-term factors such as market saturation and innovation shocks from substitute products.