I've never been a big fan of buying and selling stocks in a portfolio based on qualitative measures, such as whether you like or hate the company's products.
Apple investors who have bought its stock because they love their iPad or iPod or iPhone, I'm looking at you.
Instead, I think that any investor who is looking to make money in the market needs a more quantitative basis for stock picks. And the two that I have always recommended are price-to-earnings ratio and price-to-book ratio.
The P/E ratio compares a company's stock price to its current or future earnings. Let's say there's a company that currently trading at $30 per share, and analysts predict that the company will report earnings of $1.50 per share in 2011. If you divide the two numbers, then you discover that the company has a P/E ratio of 20.
If this is a stock that interests you, then you need to compare that P/E ratio of 20 to similar companies and the overall market.
Let's take a look at Apple's numbers. At Friday's stock close of $350.56, Apple's shares were trading at 15.3 times earnings because the analysts that follow the company are estimating that it will earn $22.90 per share in its current fiscal year.
If you looked at the analyst estimates of $26.15 earnings per share for 2012, then Apple's stock is trading at about 13.4 times earnings.
How does that compare to other tech companies? Amazon.com is trading at about 58 times its projected 2011 earnings and about 41 times its projected 2012 earnings.
Google is trading at about 18.25 times its projected 2011 earnings and at about 15.7 times its projected 2012 earnings.
By making these quantitative comparisons, we can see that Apple, despite its lofty stock price, is actually a pretty good buy right now compared to other tech stocks.
Then there's the price-to-book ratio. This compares the company's stock price to its book value — the value of all of the company's assets if they had to be sold today.
A company whose stock is trading at $30 per share that had a book value of $20 would be trading at 1.5 times its book value. Most companies trade about their book value. Again, you want to compare the P/B ratio against companies in the same industry.
Let's use Apple again for our example. It's currently trading at about six times its book value. Google is trading at 4.3x book value, while Amazon.com is trading at 12.3x book. Netflix is trading at a whopping 42.8x book.
Based on these numbers, it still looks like Apple is a good buy, but it's maybe not as compelling a purchase as the P/E numbers showed because Google has a lower P/B value. And by the way, you don't have to crunch these numbers yourself. I took them all off the Yahoo! Finance site. Any financial news site will have them.
As my iPad charges next to me, I'd rather be able to use these numbers to rationalize to my friends why I'm buying Apple stock than just telling them that my wife's iPad is the coolest thing I've ever seen.
