One Up On Wall Street: How To Use What You Already Know To Make Money In

by Peter Lynch

BEWARE THE STOCK WITH THE EXCITING NAME

As often as a dull name in a good company keeps early buyers away, a flashy name in a mediocre company attracts investors and gives them a false sense of security.

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.

When you buy a stock in a fast-growing company, you’re really betting on its chances to earn more money in the future.

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.

(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.

(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.)

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.

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.

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,

Future earnings—there’s the rub. How do you predict those? The best you can get from current earnings is an educated guess whether a stock is fairly priced.

There are five basic ways a company can increase earnings*: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close, or otherwise dispose of a losing operation. These are the factors to investigate as you develop the story. If you have an edge, this is where it’s going to be most helpful.

Already you’ve found out whether you’re dealing with a slow grower, a stalwart, a fast grower, a turnaround, an asset play, or a cyclical. The p/e ratio has given you a rough idea of whether the stock, as currently priced, is undervalued or overvalued relative to its immediate prospects. The next step is to learn as much as possible about what the company is doing to bring about the added prosperity, the growth spurt, or whatever happy event is expected to occur. This is known as the “story.”

Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I’m interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. The two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once you’re able to tell the story of a stock to your family, your friends, or the dog (and I don’t mean “a guy on the bus says Caesars World is a takeover”), and so that even a child could understand it, then you have a proper grasp of the situation.

Here are some of the topics that might be addressed in the monologue:

If it’s a slow-growing company you’re t...

If it’s a cyclical company you’re thinking about, then your script revolves around business conditions, inventories, and prices.

If it’s an asset play, then what are the assets, how much are they worth?

If it’s a turnaround, then has the company gone about improving its fortunes, and is the plan working so far?

If it’s a stalwart, then the key issues are the p/e ratio, whether the stock already has had a dramatic run-up in price in recent months, and what, if anything, is happening to accelerate the growth rate.

If it is a fast grower, then where and how can it continue to grow fast?

Those are some basic themes for the story, and you can fill in as much detail as you want. The more you know the better. I often devote several hours to developing a script, though that’s not always necessary.

Asking about the competition is one of my favorite techniques for finding promising new stocks. Muckamucks speak negatively about the competition ninety-five percent of the time, and it doesn’t mean much. But when an executive of one company admits he’s impressed by another company, you can bet that company is doing something right. Nothing could be more bullish than begrudging admiration from a rival.

That’s one reason I prefer hotel and restaurant stocks to technology stocks—the minute you invest in an exciting new technology, a more exciting and newer technology is brought out of somebody else’s lab.

If they aren’t already doing it, then don’t invest in it.

GETTING THE MOST OUT OF A BROKER

You know what Mark Twain says: ‘October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.’ ”

CALLING THE COMPANY

Before you call the company, it’s advisable to prepare your questions, and you needn’t lead off with “Why is the stock going down?” Asking why the stock is going down immediately brands you as a neophyte and undeserving of serious response. In most cases a company has no idea why the stock is going down.

Earnings are a good topic,

When looking at the same sky, people in mature industries see clouds where people in immature industries see pie.

VISITING HEADQUARTERS

I could never prove this scientifically, but if you can’t imagine how a company representative could ever get that rich, chances are you’re right.

From the time Carolyn discovered L’eggs in the supermarket, and I discovered Taco Bell via the burrito, I’ve continued to believe that wandering through stores and tasting things is a fundamental investment strategy. It’s certainly no substitute for asking key questions, as the Bildner’s case proves. But when you’re developing a story, it’s reassuring to be able to check out the practical end of it.

The balance sheet lists the assets and then the liabilities. That’s critical to me.

In the top column marked Current Assets, I notice that the company has $5.672 billion in cash and cash items, plus $4.424 billion in marketable securities. Adding these two items together, I get the company’s current overall-cash position, which I round off to $10.1 billion. Comparing the 1987 cash to the 1986 cash in the right-hand column, I see that Ford is socking away more and more cash. This is a sure sign of prosperity. Then I go to the other half of the balance sheet, down to the entry that says “long-term debt.” Here I see that the 1987 long-term debt is $1.75 billion, considerably reduced from last year’s long-term debt. Debt reduction is another sign of prosperity. When cash increases relative to debt, it’s an improving balance sheet. When it’s the other way around, it’s a deteriorating balance sheet. Subtracting the long-term debt from the cash, I arrive at $8.35 billion, Ford’s “net cash” position. The cash and cash assets alone exceed the debt by $8.35 billion. When cash exceeds debt it’s very favorable. No matter what happens, Ford isn’t about to go out of business.

Next, I move on to the 10-Year Financial Summary, located on page 38, to get a look at the ten-year picture. I discover that there are 511 million shares outstanding. I can also see that the number has been reduced in each of the past two years. This means that Ford has been buying back its own shares, another positive step.

Dividing the $8.35 billion in cash and cash assets by the 511 million shares outstanding, I conclude that there’s $16.30 in net cash to go along with every share of Ford. Why this is important will be apparent in the next chapter.

Here, and not in any particular order of importance, are the various numbers worth noticing:

PERCENT OF SALES

When I’m interested in a company because of a particular product—such as L’eggs, Pampers, Bufferin, or Lexan plastic—the first thing I want to know is what that product means to the company i...

THE PRICE/EARNINGS RATIO

The p/e ratio of any company that’s fairly priced will equal its growth rate.

But if the p/e ratio is less than the growth rate, you may have found yourself a bargain.

A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account. Find the long-term growth rate (say, Company X’s is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X’s is 10). 12 plus 3 divided by 10 is 1.5.

THE CASH POSITION

Nevertheless, it’s always advisable to check the cash position (and the value of related businesses) as part of your research.

THE DEBT FACTOR