Measuring price, quality is the essence of investing

To maximize your investing results, you need to find promising companies, evaluate their health and prospects, decide whether and when to invest in them, and then whether and when to sell. Underlying all those steps are two questions that you need to be able to answer about any of your investments:

(1) Is this a strong, high-quality company?

(2) Is the company’s stock priced attractively or not right now?

If you don’t address both questions, you might end up buying grossly overvalued shares of a wonderful company, or you might snap up shares of a hapless, doomed business at what seems like a bargain price. Investors have lost bundles doing either or both of those things.

The first question is much easier to answer than the second. An enterprise such as Coca-Cola or Johnson & Johnson or Avon might quickly appear to be a first-rate firm. But at what price is it a good buy?

Some investors believe that as long as you’ve got a tip-top company, the price isn’t that important. They figure that if an overvalued company keeps growing, it’ll eventually grow into and surpass its price. (This can happen, but it might take a long time, and sometimes it doesn’t happen.) Conveniently, most company evaluation measures are related to either quality or price. Quality-related measures reflect a firm’s profitability, growth and health. They include sales and earnings growth rates, profit margins, return on equity (ROE), return on assets (ROA), inventory turnover, market share and management quality, among other things.

Price-related measures help you determine whether the stock is overpriced, underpriced or priced just right. They address a company’s valuation or stock price and include market capitalization, enterprise value, price-to-earnings (P/E) ratio and price-to-sales ratio.

Learn more about how to crunch these numbers in our “Crack the Code” How-to Guide at www.fool.com/shop/howto and also at http://stocks.about.com/od/ evaluatingstocks.

Ask the Fool

Q: When seeking stocks in which to invest, should I look for companies with high earnings per share (EPS)? Is that better than low EPS? — H.T., Muskegon, Mich.

A: In many ways, the earnings per share amount is meaningless by itself. Here’s why. Imagine that Scruffy’s Chicken Shack (ticker: BUKBUK) has net income of $10 million this year. If it has 10 million shares of stock outstanding, then its EPS is $1 ($10 million divided by 10 million is 1). If Scruffy’s issues more stock and suddenly has 12 million shares outstanding, its EPS will be lower, at 83 cents ($10 million divided by 12 million is .83).

You could be looking at two terrific, healthy growing companies, each of which sports the same net income amount. If one has half as many shares as the other, its EPS will be twice as big. That doesn’t mean that it’s a better or worse company, and there’s no perfect number of shares for a company to have.

In general, rising EPS numbers over time is good. Also, EPS can be useful when you compare it with other numbers. The price-to-earnings (or “P/E”) ratio, for example, is typically calculated by dividing the current stock price by trailing EPS. Keep in mind, too, that even net income isn’t as meaningful as you might think, because a company’s earnings can be manipulated legally via various accounting maneuvers.

Q: Can you recommend any books on value investing? — R.K., Garden City, N.Y.

A: Try “Value Investing: From Graham to Buffett and Beyond” by Bruce Greenwald et al. (Wiley, $20) or “The Intelligent Investor” by Benjamin Graham (Collins, $20). “One Up On Wall Street” by Peter Lynch and John Rothchild (Fireside, $15), meanwhile, offers a good introduction to investing.

My smartest investment

After reading your positive column about the company, noticing they had expanded to the town I live in, looking at their financials and listening to my son-in-law’s appraisal of their product, I bought some stock in Peet’s Coffee & Tea in 2004. My broker did not think it was publicly traded and questioned it as a long-term investment. So far it is up over 46 percent in the short time I have owned it, and even with an outrageous P/E ratio, the stock still looks like a good moderate-term investment. Besides, I like their coffee. Thanks for the advice. — Jerry Newman, Sebastopol, Calif.

The Fool Responds: Congratulations. Keep in mind that an outrageous P/E ratio sometimes signals an overpriced stock that could fall back to more reasonable levels. Still, you were smart to study the company before buying any shares, and it’s a plus that you like the company’s products. That can make it more fun to keep up with the firm. Learn more about Peet’s in an article at www.fool.com/News/mft/ 2005/mft05080419.htm.