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Difference between equity prices and their valuation

Richard Loth

A few weeks ago, the Vail Dailys Edward Stoner wrote a brief article about the recent jump in Vail Resorts (MTN) stock price. I was asked for an investment opinion on this and was quoted as having some reservations about the stock because of its high valuation.Subsequently, a reader asked whats wrong with a high value, which sounded like a positive investment quality, not a negative one, to him. Heres my answer, which should be of interest to all stock and stock fund investors.Viewed in isolation, the price of a stock doesnt tell us very much. For example, as of Monday, Vail Resorts stock price was $34.45. Was this a fair price? Was the seller selling too low or too high? Or, conversely, were buyers paying too much or too little?These are not easy questions to answer. Many factors influence the price of a stock. A companys financial fundamentals, investor sentiment, the general market environment, future business prospects, and analysts opinions all come into play. In order to provide a reasonable judgment on the fair value of a stock price, investment research uses a variety of measurements.Traditionally, these evaluative indicators look at the relationships between a stocks price and its per share earnings, sales, net worth, and cash flow. Experts differ in their views on the relative merits of these ratios. For investors, even with its recognized limitations, the price/earnings, or P/E, ratio is the best-known and most often used valuation ratio.The mechanics of the ratio are quite simple. For example, if Vail Resorts is selling for $34.45 a share (thats the P in the ratio) and its reported earnings (net income) per share is $0.64 (the E in the ratio), its valuation on a price/earnings basis is 54 ($34.45 $0.64). Investors are paying $54 for every $1 of VRs earnings. Is that a good ratio? Is it indicative of a fair value? It depends. As a generalization, growth stocks and growth stock funds tend to have higher P/E ratios because their earnings are growing at a pace above the market average. Also, P/E ratios vary among stock sectors and industries. Therefore, it is extremely important to judge a particular companys P/E by its historical level, by similar company comparisons, and by market and industry averages.Using Vail Resorts as an example, its high-low P/E for 2005 has been between 54 and 31. Historically, it has not had a consistent range, but has tended to trade at the high-end. However, according to TDWaterhouse data, VRs P/E of 54 is way above the S&P 500 and industry averages of 18 and 21, respectively. This information is publicly available on financial Internet Web sites and investment research publications like Value Line and Morningstar, among others.In this context, VRs stock looks very pricey to value investors who are looking for stocks with low P/Es. Even if Vail Resorts is considered in the growth stock category, which seems to be somewhat of a stretch, its valuation is still very high. The average P/E ratio of the growth-stock heavy NASDAQ Index is only 37.Using the price/earnings ratio is not fool proof in determining the fairness of a stock prices valuation. But, its far better than using guesswork when it comes to making a judgment on buying, holding, or selling a stock at a given price. Investors must take care with high-valuation stocks and stock mutual funds. While these might represent worthwhile investing opportunities, theres also increasing danger that youll end up buying high and someday selling low. Whats not to like about a stock price that goes up? Just make sure that its valuation makes sense. The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing and an independent registered investment adviser. Loth can be reached at 328-5591 or mentor@centurytel.net.Vail, Colorado


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