With the recent dips and bumps in the stock market, there is no better time to get educated on the stock market. So I want to go over some of the basics of the stock market in this blog post. I'm not a stock market buff, or guru of the market, but I understand some of the basics, and I want to give you some basic ways to value stocks and a few basic stock market terms that will help you do the same. I am using basic terms and generic examples, so remember, it gets much more in depth than this, but this will get you started.
Let's get started with a few definitions:
Stocks - Shares of a company. When you buy shares of a stock, you essentially become a partial owner of the company's profits. You can buy single stocks or groups of stocks such as mutual funds, index funds, and exchange traded funds (ETFs).
There is a big difference between the "price" of a stock and the "value" of a stock. When buying individual stocks, always attempt to purchase stocks that are priced less than what the stock is valued at. Or said another way: you should buy stocks where the value of that stock is greater than the current price of the stock. So you want to buy stocks that should be priced higher, based on their value, then they are currently priced at. This is called "value investing", and it's a win for you!
Price (cost) of a stock = The price of an individual stock. This is easy because prices are listed everywhere. You can find the price of a stock on googlefinance.com, www.morningstar.com, etc.
Value of a stock = What the stock is actually work. This is not published anywhere, and it is more difficult to determine, and can take on many variables. For simplicity of this blog post, I will give you a basic definition.
The BIG difference between a stock's Price and its Value:
Example: When you are looking to buy a house that is priced greater than all of the comparable homes around it, then the house you are wanting to buy is overpriced, based on the value of the houses around it. This is bad, so you wouldn't buy.
On the flip side, when you are looking to buy a house that is priced less than all of the comparable homes around it, then the house you are wanting to buy is underpriced, based on the value of similar homes around it. This is good, so you would buy.
Apply the above examples to the stock market. The only difference between a house and stocks is that with stocks there may be a dozen other variables, like emotions like fear and over optimism and over pessimism, lack of research into a company, consumer buying habits, economic or market trends.
When investing, you want to determine whether or not a stock is overpriced, underpriced, or fairly priced, before buying it. In order to do this, you have to learn how to assign value to a stock:
How to know when you should buy a stock?
Here is how you can assign value to a stock to determine if it's overvalued, undervalued, or valued appropriately:
Earnings = Measure of how profitable a company was in the past year. Earnings are a company's profits in the past 12 months. Usually determines the financial strength of a company. The higher the Earnings per share (EPS), then the more likely the company is strong enough to pay dividends and stay afloat.
Earnings per share (EPS) = Company's earnings (profits or net income) in the past 12 months divided by a company's total outstanding shares.
The EPS is the E in the P/E Ratio
Price Earnings Ratio (P/E Ratio) - This helps assess a stock by helping you determine the value of a stock. The P/E Ratio measures how much an investor makes per each dollar invested in a stock.
P/E Ratio = Current price of a stock per share divided by the EPS.
Example: If the current price of a stock is $100 per share and the EPS is $5, then the P/E Ratio is 20. $100 divided by $5 = 20. In other words, look at it like this: you are paying $100 per share of a stock for a claim on earnings per share of $5.
Underpriced Stock has a P/E ratio of under 10.
Fairly priced Stock has a P/E ratio of around 15.
Overpriced Stock has a P/E ratio of over 20.
Stock with a P/E ratio of over 30 is considered a Bubble. And bubbles burst.
You typically never have to do these calculations yourself. Simply go to Google and type in any company's PE ratio and it will tell you exactly what their current EPS is, and their current P/E ratio. It's that simple! Now you can value stocks. However, remember all of the other variables that come in to play when you value a stock. Don't only use the EPS and P/E ratio as the sole determining factor to purchase, or not to purchase a stock.
Other helpful terms:
Yield or Earnings Yield - Another way of valuing a stock. Measures the return you get from an investment in a stock, based on the dividend you receive. Or it's another measure of "RISK". The yield is the reverse of the P/E Ratio.
Yield = Last twelve months of EPS divided by the current price of a stock.
Example: A company has an EPS for the last twelve months of $5 per share, and the company is currently priced at $100 per share. Than the Yield would simply be $.05 or 5%
Index - Just like the index in the back of a book doesn't contain every word in the book, but it contains a group of words, or information, in the body of a book. An index is a subset of the stock market. An index can contain a specific group of companies that are listed on indexes such as the Dow Jones, the NASDAQ, or the S&P 500. The S&P 500 is about 70% of the entire market capitalization (explained later), so it's an index that is a good indicator of the entire market. An index can also be described as a subset, or group, of stocks, which either represents the market as a whole (such as the S&P 500) or a specific sector of the market, like technology, retail companies, or healthcare.
Capital Gains - An increase in the value of an asset. A capital loss is a decrease in the value of an asset.
Dividend - A portion of profits a company's Board of Directors decides to pay its investors. Paid in cash, stocks, or any asset. Most company's do quarterly dividends per share, also called earnings per share (see below).
Initial Public Offering (IPO) - When a private company offers their shares to the public for the first time.
Market Capitalization - The total dollar value of a company's outstanding shares of their stock. Outstanding shares are the shares of stocks that have been authorized, issued, and purchased.
Market Capitalization = Price of a company's individual stock times the total number of outstanding shares
To summarize all of this, let me reiterate that this is a simple way to look at stocks, but it's a great introduction to the basics. To value a stock, understand the P/E ratio, which is simply a stock's price divided by the earnings per share (EPS). And the EPS measures a company's profitability because it's the net income of a company over the past twelve months divided by the number of outstanding shares of a company. You can also measure a stock's value by the Yield, or Earnings Yield. The Earnings yield is simply the EPS divided by the stock's current price. Again, all of this is usually figured for you all over the internet.
I hope this helps. Happy investing.