When you buy a stock, you’re acquiring a piece of the company, so profitability is an important consideration. Imagine buying a store. Before deciding how much to spend, you want to know how much money that store makes. If it makes a lot, you’ll have to pay more to acquire it.
Now imagine dividing the store into a thousand ownership pieces. These pieces are similar to stock shares, in the sense that you are acquiring a piece of the business, rather than the whole thing. The business can pay you for your ownership stake in several ways. It can give you a portion of theprofits, which for shareholders comes in the form of a periodic dividend. It can continue to expand the business, reinvesting money earned to increase profitability and raise the overall value of the business. In such cases, a more valuable business makes each piece, or share, of the business more valuable. In such a scenario, the more valuable share merits a higher price, giving the share’s owner capital appreciation, also known as a rising stock price.
Not every company pays a dividend. In fact, many fast-growing companies prefer to reinvest their cash rather than pay a dividend. Large, steadier companies are more likely to pay a dividend than are their smaller, more volatile counterparts.
The most common measure for stocks is the price to earnings ratio, known as the P/E. This measure, available in stock tables, takes the share price and divides it by a company’s annual net income. So a stock trading for $20 and boasting annual net income of $2 a share would have a price/earnings ratio, or P/E, of 10. Market experts disagree about what constitutes a cheap or expensive stock. Historically, stocks have averaged a P/E in the mid teens, though in recent years, the market P/E has been higher, often nearer to 20. As a general rule of thumb, stocks with P/Es higher than the broader market P/E are considered expensive, while stocks with a below-market P/E are considered cheaper.
But P/Es aren’t a perfect measure. A company that is small and growing fast may have a very high P/E, because it may earns little but has a high stock price. If the company can maintain a strong growth rate and rapidly increase its earnings, a stock that looks expensive on a P/E basis can quickly seem like a bargain. Conversely, a company may have a low P/E because its stock has been slammed in anticipation of poor future earnings. Thus, what looks like a “cheap” stock may be cheap because most people have decided that it’s a bad investment. Such a temptingly low P/E related to a bad company is called a “value trap.”
Other popular measures include the dividend yield, price-to-book and, sometimes, price-to-sales. These are simple ratios that examine the stock price against the second figure, and these measures can also be easily found by studying stock tables.
Investors seeking better value seek out stocks paying higher yields than the overall market, but that’s just one consideration for an investor when deciding whether or not to purchase a stock.
Picking stocks is much like evaluating any business or company you might consider buying. After all, when you buy a stock, you’re essentially purchasing a stake in a business.
Summary and Tips
The most common measure of a stock is the price/earnings, or P/E ratio, which takes the share price and divides it by a company's annual net income.
Generally, stocks with P/Es higher than the broader market P/E are considered expensive, while lower-P/E stocks are considered not so expensive.
Don't automatically go for stocks with low P/Es simply because they are cheaper. Cheap stocks aren't always good stocks.
The following is adapted from “The Complete Money and Investing Guidebook” by Dave Kansas.
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