MOTLEYFOOL

August 15, 1999

Extra Shares

Q: If I get extra shares of a stock in a 2-for-1 split, is that a capital gain or a dividend? -- F.G., Sacramento

A: Run-of-the-mill stock splits are termed "dividends" by the IRS, but they're not taxable ones, as they don't pay you any money.

Say you buy 100 shares of Amalgamated Chorus Girls Inc. (ticker: KICKS) for \$30 each. It splits 2-for-1, and you now own 200 shares at a cost basis of \$15 per share. The value of your investment hasn't changed. Capital gains occur only when you sell some shares.

Q: How can a company have a price-to-earnings (P/E) ratio of 1,000? -- R.W.Q., Rutland, Vt.

A: The P/E ratio is the company's current stock price divided by its annual earnings per share (EPS). It's a simple fraction. As long as there are no earnings (such as with start-ups, or companies temporarily or permanently in trouble), the bottom of the fraction is zero and a P/E can't be calculated. But as soon as a tiny bit of profit occurs, the fraction suddenly comes alive. With a bigger number on top (the stock price) and a very small bottom number (the EPS), the P/E is large.

Imagine a rapidly growing Igloo Construction start-up called Ice Boxes (ticker: BRRRR). For its first five years, it reports losses and has no P/E ratio. In year six, it finally generates a profit of \$0.01 per share. With its stock price at \$20, its P/E is a whopping 2,000 (20 divided by 0.01). The following year, if its EPS is \$0.05 (up 400 percent!) and its stock price remains \$20, its P/E will be 400. If its stock price hits \$35 when its EPS is \$0.40, the P/E will be 88.

THE FOOL SCHOOL

Two Issues: Quality and Price

Some members of our online community have been wondering what they need to consider when studying a company in which to possibly invest. If they're foolish (with a small "f"), they may look only at the price-to-earnings (P/E) ratio. Fools (with a capital "F") will consider many measures, such as profit margins, earnings growth rates and return on equity. One important thing to keep in mind is that there are two key questions that need to be answered by the information you gather:

1. Is this a high-quality company that I'd love to own a piece of?

2. Is the price right to buy it now?

Fools generally agree that it's best to invest in high-quality companies, but they put different emphases on the second question. To some, as long as you've got a terrific company, the price isn't that important because the company will keep growing. To others, buying at a good price is important in order to reduce risk and maximize gain. But to just about all Fools, it's vital to understand a company's business and get a handle on its quality.

Conveniently, most company evaluation measures are related to either quality or price. Here's where some measures fall.

Company quality: sales and earnings growth, margins and margin growth, return on equity, return on invested capital, leverage, inventory turnover, flow ratio, return on assets, product and service offerings, market share, competitive positioning, proprietary technology or knowledge, brand strength, management savvy.

Stock price: market capitalization, enterprise value, price-to-earnings (P/E) ratio, price-to-sales ratio, price-to-cash flow ratio, price-to-book value ratio, value-per-subscriber measures, dividend yield.

Quality-related measures will help you understand how efficiently and profitably the company is run, how robust its financial condition is, and how quickly it's growing. Price-related measures will help you determine whether the stock is priced attractively.

We've discussed many of these company evaluation measures already in this space, and we'll continue to do so in future issues. If you just can't wait to learn more about them, head over to www.fool.com, click on Fool School and visit our How to Value Stocks area. Alternatively, head to a library and check out our "Motley Fool Investment Workbook" (Fireside, \$13).

MY DUMBEST INVESTMENT

Sell the Smelly Dog

Some 20 years ago, my mom bought gold at around \$600 per ounce when it was going through the roof. She rejoiced when it was \$800-ish. She held it through the downswing and still owns it today because she's too proud to take a loss. She's determined that it will someday at least break even. However, had she sold at even \$200 per ounce, taken the loss and put the pittance in just about anything else, she would have very likely realized a profit by now. Sometimes you've got to swallow your pride and get on with your Foolish life. Sell the smelly dog and never look back. Mom now has the Fool's Web address! -- John Schmidt, Portland, Ore.

The Fool Responds: What's lost at any given point should be considered a "sunk cost." Don't worry about trying to make it back in the bad investment -- you might make it back in another, better one. Your money should be plunked into the investments in which you have the most faith. Good luck, Mom!

Foolish Trivia

One of my first projects was developing the software for Apple's LaserWriter printer. I was a major player in the desktop publishing revolution. Most images on the World Wide Web have been created with one of my products. (Some of their names are variations on SheetCreator, BorderGenerator, Gymnast, SnapshotOutlet, and Elucidator.) I bought Aldus in 1994 and avoided a hostile takeover by an elementary particle in 1998. I went public in 1986, and my stock has advanced some 600 percent in the last decade. I help fund new technologies through venture capital investments. Who am I?

Last Week's Trivia Answer: My namesake product was invented in San Diego in 1953, when the three employees of the Rocket Chemical Co. tried to develop rust-prevention solvents and degreasers for the aerospace industry. It took them 40 tries before they developed the formula for water displacement. The product became a hit with consumers after employees began smuggling some home to use around the house. It's now in 80 percent of American homes. A bus driver in Asia used it to remove a python from the undercarriage of his bus and some police officers used it to remove a naked burglar trapped in an air conditioning vent. Who am I? (Answer: WD-40 Co.)

THE FOOL TAKE

Bottom-Line Retailing

Some people pay little attention to wholesale clubs like Costco, thinking they don't need 96-ounce cans of tuna or 5-pound cans of ketchup. Costco nonetheless has one of the better sales trends in retailing, with sales in stores open at least a year averaging an 8 percent to 9 percent rise over the past two years.

Costco operates 290 warehouse clubs primarily in the United States and Canada, offering a limited selection of fast-selling products -- such as food, electronics and household supplies -- at rock-bottom prices. If you think Kmart is cheap, you probably haven't been to a warehouse club. While Kmart charges customers about 28 percent more than it pays for merchandise, Costco charges only 11 percent more.

The company minimizes expenses by selling only quickly moving merchandise, buying in massive quantities, and operating bare-bones warehouses that minimize inventory loss. It charges an annual membership fee to its 12.4 million members, resulting in \$439 million in recurring revenues last year. Most of this money drops straight to the bottom line.

The company's earnings per share increased from \$1.66 in fiscal 1997 to \$1.96 last year. For fiscal 1999, which ends this month, the First Call analyst consensus estimate calls for another 19 percent profit improvement to \$2.34 per share. Over the longer term, analysts project growth of about 15 percent. Costco appears worth some further research. Perhaps you'll want to fill your shopping cart with its stock.

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