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We have mentioned the P/E ratio and how it is widely used to evaluate stocks and indices. In our previous post, we used it to evaluate the market as a whole to get a feel for if Mr. Market is overvalued, neutral or undervalued. This time, we can take a look at it on a company level and see how it works compared to other methodologies.

P/E = Price divided by Earnings. Price would be the price of the stock and earnings would be the earnings of the stock. Earnings is the Net Income of the firm after all expenses including interest payments. Pretty simple right?

Next, P/E ratios can fall under trailing or forward/leading P/E ratios. Trailing uses the earnings of the past 4 quarters and forward P/E uses the estimated next 4 quarters of earnings. You can look at a P/E ratio as the amount of time it will take to recoup/double your investment. A P/E ratio of 10 or stock price of 10 with earnings of 1, or a stock price of 20, with earnings of 2, means it will take 10 years to earn 100%. So generally speaking, a lower P/E ratio is better.

There are 2 issues with the P/E ratio as a measurement. First, what if earnings is negative or very small. It makes it hard to compare to companies with positive P/E ratios or comparing P/Es of 15 vs 500. Also, having a negative P/E ratio does not mean the firm is worthless either. Sometimes when earnings are negative, it will just be reported as a P/E of 0.

The second issue is concerning the capital structure of the stock/company in question. Take a look at 2 mythical companies below. Assuming everything is exactly the same except how they were funded, one with more debt and one with more equity. You can see the resulting difference in net income.

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Assuming both firms are in a very stable industry with no chance of the business dying off and having the same amount of shares outstanding, if you used the P/E ratio to compare these two firms, you would have 2 very different results.

One method of working around this is a ratio called EV/EBITDA. EV stands for enterprise value. The math for EV is market cap of the firm + debt + minority interest + preferred shares - cash and cash equivalents. Or in other words, it is what the company is really worth. (Note how the price of the company should also be the measure of the company's worth)

Now EBITDA stands for Earnings Before, Interest, Taxes, Depreciation, and Amortization. In other words, the money the company makes before you factor in how the company is structured financially, with debt/equity.

What it boils down to is that you are using EV to replace Price and EBITDA to replace earnings. This will give you a measure of the value of the stock/company regardless of if it relies heavily on debt or not. Do keep in mind, firms that rely heavily on debt, have the benefit of reducing taxes for the firm, but may also be a sign of serious financial issues if they have trouble paying off their debt.

This proxy will allow you to compare the firms if capital structure is not a major consideration. In addition, it allows you to see the true operating performance of the company, as generally speaking, one company with plenty of debt can pay it down, and one company with plenty of debt, can borrow money and increase debt in their structure.

Lodestone Blog

So we all know when people buy a home, they generally put 20-40% down and get a loan from their local bank in the form of a mortgage. This mortgage takes the form of a monthly payment coming out of our wallets. We also know that we get a tax deduction for property taxes and the interest on the mortgage. One thing you may have noticed is that the interest deduction on your taxes is reduced over time. The explanation is as follows.

We can understand it more clearly if we take a deeper look at what a mortgage is and how it works in finance. I made this a short, 5 year, 4%, 500,000 loan to keep it from running too long, but what happens in the loan is exactly the same as a 30 year mortgage. The monthly payment is 9,208.26. Take a look at the numbers below. Then head over to the interest column. Notice how the number keeps dropping?

This is an amortization schedule that we use here at Lodestone Capital Solutions when we buy/sell residential and commercial properties. The tax deductible part for a residential loan is the interest. So over the life of the loan, the amount of interest deductible each year decreases as the loan balance decreases.

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One item that is not as skewed is the interest vs principal payments. As this is a 5 year loan, it is paid off quite quickly so the initial principal payments are actually larger than the interest portion of the payment. In general, for most residential 15-30 year loans, the initial interest port of the total payment will be much greater than the principal portion of the payment. For example, if I were to make this 500,000 loan, into a 30 year loan vs a 5 year loan, the first few interest payments would be, 1,666.67, 1,664.27, and 1,659.44 corresponding to principal payments of 720.41, 722.81, and 725.22. You can see the longer the loan, the larger percent the interest is of the earlier payments.

This graph below shows the general trend of what happens to principal and interest over the life of the loan.

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So what happens over time is the interest portion of the payment diminishes while the principal payment increases, keeping the monthly mortgage payments the same over the life of the mortgage and is why the interest deduction on your tax returns is reduced every year.

Lodestone Blog

College can be very hard to afford for your children. We wont' go into whether it is worthwhile or the details of the planning/savings for it, but one investment vehicle that may be helpful is the 529 plan. There are quite a few articles out there, but I wanted to cut it down to the bare bones of what the benefits are. So here it is in a quick short list:

• The donor has control over the account - meaning no new Xboxes, shiny new cars, or Vegas trips for your child.
• Contributions grow tax deferred, taxed if not used for educational purposes when taken out.
• Educational purposes include tuition, books, room, board, transportation and even computers.
• Account can be transferred to other family members, especially if you have multiple children.
• Contribution limit is 13,000 per person to the beneficiary with no gifting tax issues as of 2012.
• A maximum of 5x annual contribution limit may be made up front and the gifting may be spread out over 5 years to avoid use of the lifetime gifting limit. 5 x 13,000 = 65,000 per person or 130,000 for a married couple. The 130,000 would equal 13,000 per person, and then considered a gift each year for the next 5 years.

There it is. Short and sweet. Hope it helps!

Lodestone Blog