ASK THE FOOL

The ABCs of EPS

Q: When seeking stocks in which to invest, should I look for companies with high earnings per share (EPS)? Is that better than low EPS? – H.T., Muskegon, Mich.

A: In many ways, the earnings per share amount is meaningless by itself. Here’s why. Imagine that Scruffy’s Chicken Shack (ticker: BUKBUK) has net income of $10 million this year. If it has 10 million shares of stock outstanding, then its EPS is $1 ($10 million divided by 10 million is 1). If Scruffy’s issues more stock and suddenly has 12 million shares outstanding, its EPS will be lower, at 83 cents ($10 million divided by 12 million is .83).

You could be looking at two terrific, healthy growing companies, each of which sports the same net income amount. If one has half as many shares as the other, its EPS will be twice as big. That doesn’t mean that it’s a better or worse company, and there’s no perfect number of shares for a company to have.

In general, rising EPS numbers over time is good. Also, EPS can be useful when you compare it with other numbers. The price-to-earnings (or “P/E”) ratio, for example, is typically calculated by dividing the current stock price by trailing EPS. Keep in mind, too, that even net income isn’t as meaningful as you might think, because a company’s earnings can be manipulated legally via various accounting maneuvers.

Q: Can you recommend any books on value investing? – R.K., Garden City, N.Y.

A: Try “Value Investing: From Graham to Buffett and Beyond” by Bruce Greenwald et al. (Wiley, $20) or “The Intelligent Investor” by Benjamin Graham (Collins, $20). “One Up On Wall Street” by Peter Lynch and John Rothchild (Fireside, $15), meanwhile, offers a good introduction to investing.

FOOL’S SCHOOL

Price and Quality

To maximize your investing results, you need to find promising companies, evaluate their health and prospects, decide whether and when to invest in them, and then whether and when to sell. Underlying all those steps are two questions that you need to be able to answer about any of your investments:

(1) Is this a strong, high-quality company?

(2) Is the company’s stock priced attractively or not right now?

If you don’t address both questions, you might end up buying grossly overvalued shares of a wonderful company, or you might snap up shares of a hapless, doomed business at what seems like a bargain price. Investors have lost bundles doing either or both of those things.

The first question is much easier to answer than the second. An enterprise such as Coca-Cola or Johnson & Johnson or Avon might quickly appear to be a first-rate firm. But at what price is it a good buy?

Some investors believe that as long as you’ve got a tip-top company, the price isn’t that important. They figure that if an overvalued company keeps growing, it’ll eventually grow into and surpass its price. (This can happen, but it might take a long time, and sometimes it doesn’t happen.) More conservative investors recognize that buying at an attractive price is vital to reduce risk and maximize gain.

Conveniently, most company evaluation measures are related to either quality or price. Quality-related measures reflect a firm’s profitability, growth and health. They include sales and earnings growth rates, profit margins, return on equity (ROE), return on assets (ROA), inventory turnover, market share and management quality, among other things.

Price-related measures help you determine whether the stock is overpriced, underpriced or priced just right. They address a company’s valuation or stock price and include market capitalization, enterprise value, price-to-earnings (P/E) ratio and price-to-sales ratio.

Keep both quality and price in mind as you examine possible investments, and your portfolio will thank you. Learn more about how to crunch these numbers in our “Crack the Code” How-to Guide at www.fool.com/shop/howto and also at http://stocks.about.com/od/evaluatingstocks.

MY SMARTEST INVESTMENT

Profits Perking Up

After reading your positive column about the company, noticing they had expanded to the town I live in, looking at their financials and listening to my son-in-law’s appraisal of their product, I bought some stock in Peet’s Coffee & Tea in 2004. My broker did not think it was publicly traded and questioned it as a long-term investment. So far it is up over 46 percent in the short time I have owned it, and even with an outrageous P/E ratio, the stock still looks like a good moderate-term investment. Besides, I like their coffee. Thanks for the advice. – Jerry Newman, Sebastopol, Calif.

The Fool Responds: Congratulations. Keep in mind that an outrageous P/E ratio sometimes signals an overpriced stock that could fall back to more reasonable levels. Still, you were smart to study the company before buying any shares, and it’s a plus that you like the company’s products. That can make it more fun to keep up with the firm. Learn more about Peet’s in an article at www.fool.com/News/mft/2005/mft05080419.htm.

FOOLISH TRIVIA

Based in New York and headed by Sumner Redstone, I’m a leading global media company that has just spun off another major media company, CBS. My brands include MTV, VH1, Nickelodeon, TV Land, Spike TV, Noggin, Logo, Country Music Television, Comedy Central, BET and Paramount Pictures, while CBS businesses include the major television network, as well as UPN, Showtime, King World, CBS Radio, Simon & Schuster, Paramount amusement parks, and what used to be my billboard advertising business. I’m buying the movie studio DreamWorks SKG, and my stock ticker symbol looks like a road in Italy. Who am I?

Last Week’s Trivia Answer: Based near Dallas, I’ve averaged double-digit annual growth since I was launched in 1963 with $5,000. I’m a premier direct seller of skin care products, with annual global sales around $2 billion. My independent sales force is composed of more than 1.5 million people in more than 30 nations. My founder used the Golden Rule as her guiding philosophy, and encouraged employees and sales force members to prioritize their lives: God first, family second, career third. (She’s written several best sellers, too.) Some of my top salespeople travel in something that Bruce Springsteen has sung about. Who am I? (Answer: Mary Kay Inc.)

THE MOTLEY FOOL TAKE

IGT on a Winning Streak

This was supposed to be a soft year for slot-machine king International Game Technology (NYSE: IGT). The rush to replace yesterday’s outdated coin-spitting slots with advanced coinless technology has likely pulled demand forward, and domestic sales weren’t expected to pick back up until the next replacement cycle took hold. However, with the first quarter now officially in the books, fiscal 2006 is already shaping up to be another strong year.

Net income for the period slipped 1.4 percent to $120.6 million, but analysts had expected worse. Sales volume was sluggish on the domestic side, but the average price per machine jumped from $12,400 to $14,500, boosting domestic product revenues 13.5 percent. International sales were down for the quarter, as the sale of nearly 30,000 Terminator machines to Japan last year made for difficult year-over-year comparisons. But the remainder of the international division showed solid growth.

IGT enjoys a dominating 70 percent share of the North American slot-machine market. However, nearly half of the firm’s revenues are generated by its higher-margin gaming operations, such as leasing slot machines.

The company’s core business remains healthy. Rapidly developing technology has effectively shortened the life span of the average slot machine. With an incomparable research and development budget, IGT is simply unmatched at developing popular new games. Before long, the company should see its earnings bucket spill over once again.