There are three fundamental tools that investors use to establish value in the stock market: dividend yield, price-earnings ratio (P/E), and price-book value ratio (P/B), as shown in Figure 5.1.

Of the three measures, the primary measure of value in the stock market is the receipt of dividends, which is expressed as dividend yield. Dividend yield cuts to the chase; when all else is stripped from the bone it is the dividend yield that reveals the true value of a company’s stock.

This is not to suggest that price-to-earnings (P/E) ratios or price-to-book-value (PB) ratios are unimportant. As primary measures of value, both ratios are less than perfect; however, as confirmation measures for the value the dividend represents, both can be quite useful.

By example, if a company’s trailing 12-month earnings are $1.95 per share and the current stock price is $24 per share, by dividing $1.95 into $24, the result is 12.30, which we round down to 12. When expressed as a ratio we would say the P/E is 12 to 1. Depending on current economic and market conditions, 12 to 1 could be high, low, or somewhere in the middle.

When earnings, stock prices, and interest rates are depressed, as they typically are in a bear market, it is not uncommon for P/E ratios to fall into the single digits. Conversely, when earnings, stock prices, and interest rates are robust, as they typically are during periods of expansion, it is not uncommon for P/E ratios to rise well into the teens and twenties.

In general, depending on the overall growth rate within any stock industry group, any ratio below 15 to 1 is believed to represent fair value. In like fashion, a P/E ratio above 20 to 1 suggests that the stock price may be overvalued. However, stocks have their own personalities, and a high P/E ratio for one stock may be an acceptable ratio, depending on the company’s growth characteristics. The market will also often grant higher valuations to a particular stock or industry that captures its fancy. Our personal preference as a firm is a P/E ratio that is closer to 10 to 1.

As you can tell, there is a certain amount of subjectivity when it comes to P/E ratios, another reason why identifying the repetitive extremes of undervalue and overvalue dividend yield is so important.

The P/B ratio compares the market’s valuation of a company (price per share) to the value indicated on its financial statements (book value per share). By example, if a company’s stock price is $20 per share and the most recent book value is $10 per share, by dividing $20 by $10 the result is 2. When expressed as a ratio we would say the P/B is 2 to 1.

When the P/B ratio is one (1 to 1), it means the market value is in sync with what the company is reporting on its financial statement. When the ratio is greater than one, it means the market is willing to pay a premium above what the company reports on its financial statements. When the ratio is less than one, it can mean one of two things: The market is nervous about the value of the company and is unwilling to pay full price, or investors have incorrectly valued the stock.

For some analysts, to question the validity of book values is to commit heresy. For the truly objective analyst, however, it is difficult to overlook the obvious deficiencies in book values for making accurate valuations. For one, how assets and liabilities are valued leaves room for creative interpretation, as we have discovered recently with financial companies. Another is that some companies, such as those in the technology and service sectors, have hidden (intangible) assets such as intellectual property that are of great value, but are not reflected in the book value. Lastly, most accounting procedures fail to account for the effects of inflation on asset prices. Book value figures, therefore, can just as easily be understated as overstated.

Even the great Benjamin Graham, whose work I credit for much of my academic/intellectual development, and whose favorite measure for value identification was book values, cautioned investors that a stock does not necessarily represent good value simply because it can be purchased at or close to book value. In his book The Intelligent Investor, Graham advises investors to be cognizant, too, of the price the market is placing on shares, to know how many dollars are on hand for each dollar of short term debt, and to know that the dividend is well protected.

As is the case with earnings and the P/E ratio, book values and the P/B ratio cannot be dismissed. They are important measures of value as they can confirm the message of the dividend-yield trend.

Enlightened investors have learned there is generally one catalyst—higher earnings or management’s reasoned expectations for higher earnings—that justifies a dividend increase. Think about it. No management, particularly that of a blue chip company, wants to suffer the public embarrassment of a bad call. Before the decision to raise a dividend is made, then, management has to believe the prospects for improved earnings, now as well into the future, must be strong. No manager with a lick of sense will raise the dividend if there is any doubt about future earnings.

Throughout this book, you will read the terms undervalue and overvalue. In our lexicon, these are historically repetitive extremes of low-price/high-yield and high-price/low-yield, which we call Profiles of Value. There is no one Profile of Value that can be applied to every stock. Each stock has it unique Profile of Value that must be analyzed and evaluated individually.