Friday, October 21, 2011

Reasonable Stock Price

The first rule of investing is “do not invest in things you do not understand”. For dividend paying companies this could translate into do not invest in a company where you do not understand how they make their money.

In regards to Dividend Payout Ratios, do not invest if a company cannot afford their dividends. I am not talking about one losing quarter or year, I am talking about when a company time and time again has dividend payouts it cannot afford, or continues to pay dividends when it appears that they can no longer afford to pay at the current rate or even pay any. Pay special attention to DPR in references to Cash Flow.

Another mistake investors make is to look only at portfolio value. You should be looking at cash flow. It is only cash flow that you can spend.

Of course, the thing I want to talk about today is paying a reasonable price for a stock, and hence the title of this article. You are lucky if you pay a really low price for a stock, but although this is very nice, it is not what is always possible. However, I do suggest that if you cannot pay a reasonable price, you should forgo buying a stock and for a more reasonably priced one.

What I look at to determine is a stock price is reasonable is Price/Earnings Ratio, Graham Price, Dividend Yield and Price/Book Value Ratio. You have to look at relative as well as absolute price. I personally think that relative ratios are more important than absolute ratios. I consider absolute ratios only when the relative ratios are way out of line. Other people use different tests than I do, but I am comfortable with the method I have.

Looking at the P/E Ratio to determine if a stock is at a good price is one of the most common things that investors do. Looking at a 5 and 10 year median P/E Ratio can give you a good idea what is considered to be a relatively high or low current stock price. A reasonable P/E ratio can vary by stock, the sort of company a stock is or type of market we are in.

A particular stock may have a premium or higher P/E Ratio than others in its particular industry. This would be because investors think a stock is a “best in class” stock. An example of this would be Enbridge (TSX-ENB), which some analysts have suggested it should have a higher P/E than other pipeline companies. Tech stocks often have higher P/E Ratios than other companies. Our current market is quite low currently, but some companies and sectors are harder hit than others.

To see yesterday’s P/E Ratio and Dividend yield for the TSX index, go to TSX Money, click on TSX Market Activity and then “Indices & Constituents”. Reuters is also an interesting site as it gives, not only a stocks P/E Ratio, but also the current P/E Ratio for the Industry and Sector a stock is in. See Reuters. For Canadian Stocks, put “TO” after stock symbol, so Emera (TSX-EMA) would be EMA.TO. (Please note that Reuters is very much American market orientated.)

I have already talked about P/E Ratios. See my site for information on Price/Earnings Ratio. As I understand Price/Earnings Ratios, 10 and below is consider low, 15 – 20 is considered normal and 25 or 30 is considered high. This is just a rule of thumb. I generally compare a stock’s current P/E Ratios, using earning estimates for the year with the 5 and 10 year median P/E Ratio of a stock. I like a stock to be around the median P/E Ratio and this I think would show a reasonable price.

The Graham Price is named after Benjamin Graham who is famous for writing book called “The Intelligent Investor”. I have also written about this subject before see my site for more information on the Graham price. Here again, what I like to see, for a reasonable stock price is the current difference between the stock price and Graham Price to be close to the median difference. So, if the 10 year median difference between the stock price and the Graham Price is 5% and there is a 1% current difference, the stock price would be reasonable. On an absolute basis, you would want a stock price at or around the Graham Price.

The next test I use is the P/B Ratio. I look at the 10 year median P/B Ratio and compare it to the current P/B Ratio. Ideally, you would want to see the current P/B Ratio around the same as the current P/B Ratio which would point to a reasonable stock price. A good or cheap stock price would be if the current P/B Ratio is 80% of the 10 year median P/B Ratio. On an absolute basis, a current P/B Ratio of 1.00 shows a very good stock price as it means that the stock price is equal to the book value of the company.

The last thing that I look at is the Dividend Yield. Dividend yield depends on the philosophy of a company. Some like to and can give out good dividends. The problem if the dividend is too high is that the company will have no money to expand. However, if the company is a mature company, it may have no need for expansion money and can distribute most of the cash it earns.

Personally, I like to see a company’s dividend yield that is higher than the 5 year median dividend yield and this would point to a reasonable current stock price. A very good stock price would be when the dividend yield is higher than the 10 year median high dividend yield.

A couple of points I look to make here. I also like companies that increase their dividends consistently (but not necessarily yearly) more than the rate of inflation. (Background inflation tends to be at 3% per year; so basically, I want a company with 5 and 10 year dividend growth at 3%, at the least.) However, if a company is paying out a dividend yield of less than 1%, I would question if the company is really a dividend paying company. On the other hand, if the yield is too high, you would have to wonder if the dividend is sustainable.

Before you buy a stock, you need to check out Dividend Payout Ratios. Analysts talk about DPR for Earnings at 60% and below and DPR for Free Cash Flow at 80% and below and 40% or lower for Cash Flow. The best companies have cash flows that are higher than earnings. I have talked about DPRs before, see my site for more information on Dividend Payout Ratios.

Another thing you might want to consider is the company’s debt rations. I have also talked about this before. See my site for further information on Debt Ratios.

Another thing that I should point out is that the current P/E Ratio and the current Graham price use the earnings estimates for this year in their calculations. The Dividend yield and the P/B Ratio use no estimates.

I do not wait around for a stock I like to get to a reasonable price. If I want to buy, I will buy something else. There is always something at a reasonable price.

This blog is meant for educational purposes only, and is not to provide investment advice. Before making any investment decision, you should always do your own research or consult an investment professional. See my website for stocks followed and investment notes. Follow me on twitter.


  1. Susan,

    Thank you so much. There is so much good information here; I am going to read this a few more times.

    You are so right saying that we should be looking at cash flow instead of portfolio value. However, if your portfolio value goes down, it is difficult to feel good about it even with a decent cash flow. For example, let say your portfolio value is $100,000 and it goes down to $70,000. Your cash flow stays the same. If you need $100,000 for something, but now you don’t have $100,000 anymore. You sell everything and you only have $70,000. This may be a bad example since an investor living on dividend income would never sell everything.


  2. It is a pleasure to have this type of important information. Keep it up please. We would like to get more thoughtful words from you again and again.