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Lesson 12. Evaluating Stocks > The Price/Earnings Ratio - Pg. 70

Evaluating Stocks 70 Current/Dividend Yield The current or dividend yield indicates the percentage represented by the annual dividend payments relative to price of the stock. In other words, how much money did you make from your investment (your investment being the stock you purchased)? If this type of measurement is sounding vaguely familiar, that is because the current yield is the exact opposite of the P/E ratio. In fact, the formula to determine the current yield is to flip the P/E ratio formula upside down: Earnings over 12-Month Period: $1 Current Market Price of Stock: $10 = Current Yield: .10% Thus, $1 ÷ $10 = .10. Stocks with high current yields are typically large blue chip stocks, or other stocks with limited growth potential, making them particularly attractive to investors looking for steady income streams from their stock. Since these companies have limited growth potential, most of their profits are paid out to their investors, rather than being reinvested in the company for such things as expansion or research and development. Stocks with low current yields are usually reinvesting their profits, leav- ing little if anything to pay out to their investors. Logically, then, low current yields are the terrain of growth stocks, which an investor would purchase for anticipated capital growth rather than a steady income stream. Plain English Current yield depicts the dividend payment of a stock as a percentage of the stock's market price. A current yield is the opposite of a P/E ratio. It is important, as with any measurement, to ensure that you know the baseline from which the measurement is being generated. Simply because a current yield is high or low is not an absolute indicator of anything. Remember that the current yield formula is totally dependent on the amount of dividends paid and that amount is the arbitrary decision of a company's management. That's right; no company is obligated to pay any certain amount in dividends. A company in very bad financial health might decide to pay out 90 percent of all profits in dividends, whereas a company with ex- cellent prospects may decide to pay out only 10 percent of its profits in dividends, choosing to reinvest the balance in expansion. In these cases, the current yield would then give an inaccurate picture of the company. The current yield is still an excellent tool with which to measure a company's financial success and potential. The investor must use the current yield within the context of all its background information for maximum results. Current and Debt Ratios The current ratio and the debt ratio differ from the previous measurements in that their focus is more on the company's constitution rather than its health. This means that the current and debt ratios measure the internal infrastructure of the company, including its level of leverage and its solvency potential, rather than its external dealings. Plain English Current ratio is a projection of the company's ability to meet its financial obligations and otherwise remain solvent. Debt ratio is a projection of the total debt carried by a company as compared with the assets and cash flows it maintains. Think of it this way. Say you make $100,000 a year, and your brother makes $50,000 a year. How- ever, you've got substantially more debt on credit cards than he does (probably because you didn't read Lesson 3, "How Much Do You Have to Invest?" as well as you should have). He's carrying about $5,000 in debt, or about 10 percent, while you've racked up about $50,000, or about 50 percent. It doesn't take a genius to figure out that I'm going to be a lot more comfortable lending your brother money rather than you, for a number of reasons: